Profit and Loss accounts, Balance sheets and Cash Flow Statements are at the heart of business lending. These are the financial base documents that bankers analyse and from which a ratio analysis can be derived in order to establish trends within the business and highlight significant features. Ratios are also useful in comparisons with past results, peer performance, and industry norms. These financial statements and their analysis and comparisons enable in assessing the customer’s needs and creditworthiness. The essential question to be answered is: can this business and its management make the interest and loan repayments within the agreed timescale?
Once an advance has been made, strict monitoring and control are required to ensure that the business is performing as planned and that the level of risk stays the same as was originally accepted. Prompt action will be needed to understand any deviation from the budgets agreed at the outset, and the appropriate action taken.
It is the cash flowing through the business which generates the profit that increases the net current assets and so builds up the capital, or shareholders’ funds, in the balance sheet (unless these profits are drawn out by the proprietors/shareholders). Hence the key importance of the cash flow statement, profit and loss account and balance sheet in financial analysis. Cash flow reporting will be examined later in this chapter.
The financial accounts are the “language” of the business in which the results are communicated to the management, owners and those who lend money, as well as those whom the management choose to inform. With public limited companies the information is in the public domain, but is not publicly available for private limited companies unless a search is made at Companies House for a small fee.
In this chapter we shall examine these three financial statements and some of the ratios used in their analysis. This work builds on what you have already learned about the principles of lending. As you go through this chapter you should refer to the procedures adopted by your own organization for business lending. This will enhance your knowledge and understanding of the subject.
Financial Statements
You will most likely have studied accounting earlier in your career and feel comfortable with its concepts and the contents of the financial statements. To refresh your memory of the format and layout of accounts, however, set out below are the accounts of Khan Ltd, an electrical retailer.
Rs. 1,530,000 210,000 920,000 1,130,000 252,000 878.000 652.000 Khan Ltd.
Trading, Profit and Loss Account for the year ended 31 December 2009
Rs. Rs,
Turnover
Less Cost of Sales
Stock at 1 Jan 2009 Add Purchases Less Stock at 31 Dec 2009 GROSS PROFIT
Lending: Products, Operations and Risk Management | Reference Book 1 270,000 236,000 506,000 146,000 24,000 170,000 Interest Payable
Loans repayable within 5 years 1,000
Loans repayable after 5 years 3,000 4,000
Profit on Ordinary Activities before Tax 166,000
Taxation 50,000
Profit on Ordinary Activities after tax 116,000
Unappropriated profit b/f 110,000
226,000
Ordinary Dividend 60,000
Unappropriated profit c/f Rs. 166,000
This account is produced for the company’s own uses. The main object of a trading account is to calculate the gross profit. To remind you of the definitions:
Sales is the turnover, or revenue (the total value of goods sold) by the business.
Cost of Sales = Opening Stock plus Purchases, less Closing Stock
Gross profit is simply the profit the business has made on buying and then selling goods, i.e. on trading.
Gross profit = Sales less Cost of Sales
Administration expenses cover the day-to-day running expenses of the business such as heating, lighting, rent, wages and salaries, and depreciation. Distribution expenses are costs incurred in either selling the goods or transporting them to the customer, for example, salespersons’ salaries and expenses, and advertising costs.
Companies have more information than they are required to put into the documents that they file with the Registrar of Companies. Our second example is in the “published” format.
Directors’ Remuneration 60,000 Auditors’ Remuneration 8,000 Salaries and Wages 110,000
Expenses 66,000
Motor Vehicle Costs:
Admin 16,000 Depreciation: Motor Vehicles 6,000 Machinery 4,000 Distribution Expenses Salaries 120,000 Expenses 60,000
Motor Vehicle costs:
Distribution 42,000
Depreciation:
Motor Vehicles 8,000
Machinery 6,000
Other Operating Income Rent Receivable
rence Book 1 Lending: Products, Operations and Risk Management | Reference Book 1
73
Khan Ltd.
Profit and Loss Account for the year ended 31 December 2009 Rs. Dep’n 40.000 30.0 Rs. 70,000 58.0 102,000 11.0 8,000 179,000 Creditors: Amounts falling due within one year Trade
Creditors 18,000
Other Creditors 60,000
Accruals 20,000 98,000
Net Current Assets
TOTAL ASSETS less CURRENT LIABILITIES Creditors: Amounts falling due after more than one year
Bank Loans 40,000
Debentures 20,000
A Note to the Financial Statements gives the cost of sales, and breaks down net operating expenses into distribution costs and administrative expenses. It also snows other operating income (for example, rent received) which has been netted with the above costs and expenses to give the net operating expense shown in the filed profit and loss account. Other Notes to the accounts show a statement which reconciles movements of reserves and the movement of shareholders’ funds. You will recall that retained profits are classed as reserves. To complete the set, here is the Balance Sheet.
Khan Ltd.
Balance Sheet as at 31 December 2009 Net Operating Expenses
Profit on Ordinary Activities before Interest
Interest Payable
Profit on Ordinary Activities before taxation
Tax on Profit on Ordinary Activities Profit for the financial year Dividends Retained Profit for the financial year
Share Capital
Ordinary Shares of £1 each Reserves
Profit and Loss Published Format Turnover Cost of Sales GROSS PROFIT Rs. 1,530,000 878,000 Rs. 652.000 482.000 170.0 4,000 166.000 50.0 116,00 0 60.000 Rs. 56,000 sOOO sOOO 1,000 >,000 1,000 >,000 ),000 >,000 ),000 >,000 6,000 n object i you of Published Format Fixed Assets Premises
Plant and Machinery Motor Vehicles Rs. Cost 200,000 70.000 45.0 Rs. 315,000 Rs. NBV 200,00 0 30.000 15.0 245,0 00 I) by the ck fing and
Current Assets Stock Trade Debtors Prepayments Bank and Cash
81,000 326,000 es of the goods or ’ salaries 60,000 Rs. 266,000 Authorised Issued put into lies. Our 200,000 100,000 166,000 Rs. 266,000
Lending: Products, Operations and Risk Management | Reference Book 1
This is a fair view of the company’s business within the reporting period. It must be a balanced and comprehensive analysis of the development and performance of the company with a description of the principal risks. This applies to all companies, except those that file small company accounts.
Balance Sheet
The first thing to say about a balance sheet is that it is produced “as at” a specific date. It is a summary, or “snapshot”, of the business’s financial position on that date.
Balance sheets can be categorized into those which are audited and those which are unaudited. Not all companies have to have their accounts audited, that is, verified for accuracy by someone outside the business. The requirement is determined by the level of the sales turnover in the financial year which is determined by the government.
Where a company does have to be audited or chooses to be audited, the auditors confirm in their report that they have carried out an audit and are satisfied that the final accounts provide a fair representation of the financial position of the business (if indeed this is the case). If they are not satisfied, they can qualify their report with the appropriate statement.
This report from the auditors, commonly referred to as the auditor's certificate, is a crucial part of any financial report on a business and must be read carefully.
From a lending manager’s point of view, audited accounts are better than unaudited, but even here two questions can be raised:
• When were the accounts last audited? • Who are the auditors?
A balance sheet is only correct on the day it is drawn up; it is a summary of the assets and liabilities of the business at that particular date. For the lending organization it is vital to see the most up-to-date position - a balance sheet a year out of date is insufficient.
Do you know the auditor or the accountancy firm by reputation? Although there is no requirement in law for sole traders, partnerships or small companies to have their accounts audited, the accounts should be certified by a qualified accountant. From a practical point of view, you may have to accept accounts which are several months old and in these circumstances you must obtain previous years’ accounts to compare one year with the next. If the borrower is already a customer, these should already be on file. If not, you should ask for accounts for at least the last three years, assuming the customer has been in business that long. This will allow you to establish trends and to understand how the business is performing.
Lending: Products, Operations and Risk Management | Reference Book 1
75
leference Book 1 rting if the on of at file “as at” ness’s ed and e their ide the e sales ament. udited, m audit ation of L If they opriate uditor‘s aess and re better ip; it is a particular ip-to-date putation? rtnerships accounts al point of lonths old iccounts to L customer, xounts for as been in rends and As at As at As at Rs 000s Rs 000s Rs 000sIf the proposal is from a new business, then projected figures should be produced. These can be compared with the balance sheets of similar firms whose accounts are held either by the branch or by making enquiries of colleagues or at head office.
Even when it comes to company accounts, which by law must be audited (other than for small companies), what is disclosed by the accounts depends on the size of the company, and in many cases the reliability of company accounts also depends on the individuals involved.
if the accounts have been audited by a qualified auditor, you may still feel that they are not necessarily the best set of accounts you have looked at. Again, the best example of this could come from a set of audited accounts produced for a very small company. Such a company might only have two shareholders with one of them having 99% of the ordinary shares; it need only have one director and a part-time company secretary. Any information required by the auditor would come from the one director who might also be the one who owns 99% of the shares. If the auditor was unsure of something, there is nobody to turn to for clarification other than the director or shareholder. Even if the auditor made some unkind remarks about the way the company was being run, nobody is there to do anything about it. You must sometimes rely, therefore, on the reputation of the company’s officers as to how well the accounts have been kept for the auditor.
Styles of balance sheets
You are likely to be presented with many types of balance sheets produced in a variety of styles. The layout of the balance sheet may vary, but the classification of assets and liabilities should not. Most banks re-input the information on to a standard form to provide a uniform approach and make a year-on-year trend analysis easier.
A specimen analysis form is shown below. This includes the various categories of assets and liabilities. Following that is a sample balance sheet of‘Lucky Cement’.
Yearly Analysis of Business Accounts
Branch:
... Cus tomer’s Name: ... Balance Sheet Date
Current Assets Cash & Bank Debtors
Stock - Raw Materials Finished Goods Current Liabilities
Bank Overdraft Creditors Provision for Tax Provision for Dividend
Lending: Products, Operations and Risk Management | Reference Book 1
( ... )
Rs 000s
As at Fixed Assets
Land & Buildings Plant & Machinery Other
Total Net Current and Fixed Assets Medium & Long term Liabilities
Debentures Preference Shares Unsecured Loans Directors’ Loans
Net Tangible Assets ... ... Proprietors’ Funds
Capital ... ... Reserves ... ... P & L Account ... ...
(Less) Intangible Assets ( ... ) ( ... )
Yearly Analysis of Business Accounts
Branch: ... Customer’s Name: ... Trading Results
For period to ... ...
Rs 000s Rs 000s Sales ... ...
Purchases ... ... Other Cost of Sales ... ... Overheads ... ... Interest Charges ... ...
Total ... ...
Net Profit before tax ... ... Ratios
As at As at Date
Capital Adequacy Leverage = Interest Coverage Working Capital Liquid Ratio
Operating Ratio
Stock Turnover Raw Materials Stock Turnover Finished Goods Credit Allowed
Credit Received Gross Profit % Net Profit % ROCE %
Lending: Products, Operations and Risk Management | Reference Book 1 77 17 18 3,233,750 20,018,22 2 23,251,97 2 19 19 21 22 23 24 23 1 9
The ratios mentioned below along with gearing ratio are considered most important in Credit Analysis:
1. DSCR = EBITDA / (Interest Expense + CPLTD) 2. Debt/EBITDA
3. Current Ratio
Calculation of Total Debt (Only bank’s interest bearing) 4. Days Inventory
5. Days Receivables
Balance Sheet as at June 30, 2010
EQUITY AND LIABILITIES SHARE CAPITAL AND RESERVES
Share capital Reserves
NON- CURRENT LIABILITIES Long term finance
Long term deposits Deferred liabilities Deferred taxation
CURRENT LIABILITIES
Trade and other payables Accrued mark-up Short term borrowings Current
portion of long term finance CONTINGENCIES AND COMMITMENTS 26 TOTAL EQUITY AND LIABILIIES 3,233,750 21,862,179 25,095,929 Note | 2010 2009 - --- (Rupees in ‘000’) --- ASSETS NON-CURRENT ASSETS
Property, plant and equipment 5 31,378,255 30,476,87 2
Intangible assets 6 2,977 -
Long term advance 7 55,373 55,373
Long term deposits 2,175 2,175
31,438,780 30,534,42 0 CURRENT ASSETS
Stores and spares 8 4,008,288 3,411,549
Stock-in-trade 9 608,813 1,196,608
Trade debts - considered good 10 779,307 1,267,248
Loans and advances 11 105,915 108,876
Trade deposits and short term prepayments
12 48,807 9,761
Other receivables 13 184,805 59,251
Tax refunds due from the government 14 538,812 538,812
Taxation-net 145,151 176,584
Sales tax refundable 15 117,939 40,162
Cash and bank balances 16 333,629 1,049,091 6,871,468 7,857,942 TOTAL ASSETS 38,310,244 38,392,36 2 1,658,600 4,300,000 31,957 28,589 319,217 234,633 1,562,850 1,478,490 3,572,624 6,041,712 3,043,32 0 2,677,356 155,50 0 233,381 6,267,11 2 6,187,941 17JL75 9 - 9,641,691 9,098,678 38,310,244 39,392,362
Lending: Products, Operations and Risk Management | Reference Book 1