Part A: Reading the statements
Financial statement analysis for lenders
Key takeaways
- Financial reporting produces the statements; financial statement analysis reads them for a decision. For a credit analyst the decision is whether the borrower can and will repay, on what terms, and what to watch afterwards.
- The audit gives reasonable assurance, not a guarantee: read the type of opinion first, because a qualified, adverse or disclaimed opinion, or a going concern paragraph, changes how far every later figure can be trusted.
- The analyst draws on financial sources (the five statements and their notes) and non-financial ones (constitution, CR12, beneficial ownership, board resolutions, management commentary, sustainability and integrated reports, ratings, regulatory filings, the press, industry benchmarks).
- Analysis runs top down (economy, industry, company) or bottom up (company first), and always through the same steps: purpose, data collection, processing, analysis, recommendation and periodic review.
What financial statement analysis is
Financial statement analysis is the process of selecting, comparing and interpreting the information in an entity's financial statements, together with the information around them, so that a user can make a decision. The statements themselves are only a record. Analysis turns them into judgements: is the business profitable enough, is its profit backed by cash, can it meet its obligations as they fall due, and is its position getting better or worse?
For a credit manager the decision is a lending or trade credit decision. An equity investor asks how much the business will be worth; a lender asks whether it will be paid back, in full and on time, and what it can recover if it is not. That difference shapes everything in this guide. A lender cares most about cash flow, liquidity, leverage and the downside, and rather less about growth that does not reach the lender as repayment.
Financial reporting and financial statement analysis
The two activities compared
| Point of difference | Financial reporting | Financial statement analysis |
|---|---|---|
| Purpose | To produce general purpose statements for many users | To answer one user's decision question |
| Who does it | The entity's management, under the board's responsibility | The user: lender, investor, supplier, regulator |
| Rules | Governed by IFRS and the Companies Act, 2015, and audited | Governed by no standard; the analyst chooses tools to suit the question |
| Time orientation | Records what has happened in the period | Uses the past to judge the future: repayment comes from future cash |
| Output | The statements and their notes | Ratios, trends, adjusted figures, a recommendation |
Reporting and analysis depend on each other. Reporting gives the analyst comparable, audited figures to work with; analysis, by lenders and investors, is what makes reporting worth its cost and disciplines entities that report badly.
The analyst's role in the credit process
In a bank or a credit-granting company, the credit analyst is the person who turns an application into a recommendation. Financial statement analysis is the core of that work: it measures capacity (can the borrower generate the cash to repay?), capital (how much of its own money stands between the lender and a loss?) and the trend of both. It also feeds the monitoring of an account after the facility is granted, because annual and management accounts are the main evidence that a borrower is still the credit the lender approved.
Why analysis matters, and what makes it hard
- Benefits: an objective basis for the credit decision; early warning of deterioration; comparison with peers and with the borrower's own past; a basis for pricing, limits and covenants; evidence to support the decision before a credit committee.
- Change: accounting standards change (IFRS 16 put most leases on the statement of financial position; IFRS 9 changed how credit losses are provided), so a trend can break for reasons that have nothing to do with the business.
- Globalism: borrowers trade and borrow across borders, report in more than one currency and belong to groups whose other members carry risks the local statements do not show.
- Technology: new business models (platforms, subscriptions, mobile money) produce revenue and assets that traditional ratios read poorly, while data tools let analysts process far more information, including transaction data, than a set of annual accounts.
- Limitations: statements are historical and often months old; they use historical cost and ignore inflation; entities choose different accounting policies and estimates; year-end figures can be dressed; and much of what decides repayment (management quality, market position) is not in the figures at all.
Audits and internal control
The objective of an audit of financial statements is to obtain reasonable assurance about whether the statements as a whole are free from material misstatement, whether due to fraud or error, and to express an opinion on whether they are prepared, in all material respects, in accordance with the applicable framework. Reasonable assurance is a high level of assurance but not an absolute one, and the audit is designed around materiality: small errors may survive it by design.
Effective internal control matters to the analyst for two reasons. It makes the reported figures more reliable, because transactions are authorised, recorded and safeguarded; and it is evidence of management quality. Weaknesses that auditors report to management, a high turnover of finance staff, or management accounts that never reconcile to the audited figures all lower the weight the analyst can put on the numbers.
Sources of information
Financial information
Non-financial information
- Memorandum and articles of association: the company's constitution: its objects, its borrowing powers and any limits on them, and who may sign for it.
- CR12: the official record issued by the Registrar of Companies showing a company's directors and shareholders; it confirms who owns and runs the borrower.
- Register of beneficial owners: the natural persons who ultimately own or control the company, needed for know-your-customer checks and to spot connected borrowers.
- Board resolutions: the board's authority to borrow and to give security, without which a facility may be challenged.
- Auditor's report and management commentary: the opinion on the statements, and management's own discussion of performance, risks, strategy and outlook.
- Sustainability and integrated reports: environmental, social and governance information and how the business creates value over time; increasingly relevant where climate or social risks can impair repayment.
- External views: credit rating agency reports, credit reference bureau reports, industry experts' comments, industry benchmarks, filings with regulators, press reports and the borrower's strategic plan.
Non-financial sources answer different questions
The statements tell you whether the borrower can pay. The constitution, CR12 and board resolutions tell you whether it can legally borrow and who stands behind it; management commentary and the strategic plan tell you where it is going; ratings, the bureau and the press tell you how others see it. A good analysis uses both kinds.
Approaches to the analysis
A top-down approach starts with the macroeconomic environment (growth, inflation, interest and exchange rates, government policy), narrows to the industry (its growth, competition, regulation and cyclicality) and only then reaches the company. It suits a lender building a sector view or lending to a borrower in a volatile industry. A bottom-up approach starts with the company's own statements and works outward only as far as the findings require. It suits a lender assessing a well-known borrower in a stable sector. Most credit reports combine the two: the company figures are read against the industry and the economy they sit in.
Steps in the analysis
- Define the purpose and context: a new term loan, a trade credit limit, a renewal, a covenant review. The purpose decides which questions matter.
- Collect the data: at least three years of audited statements, recent management accounts, projections, and the non-financial information.
- Process the data: spread the statements into a standard format, adjust for non-recurring items and accounting differences, and compute common-size figures, trends and ratios.
- Analyse and interpret: compare with prior years, peers and covenants; explain the causes; identify the risks and the mitigants.
- Communicate the recommendation: lend, on what terms, with what security and covenants, or decline, set out in a credit report.
- Review periodically: follow up with each new set of accounts, covenant certificates and account behaviour.
Self-check
(a) A supplier is considering a large credit limit for a new distributor. Explain why the supplier's analyst should read the auditor's report before computing any ratio. (4 marks)
(b) Name four non-financial sources the analyst should request and state what each would tell the supplier. (8 marks)
Show worked answer
(a) Every ratio assumes the figures are reliable. The auditor's report says how far they can be relied on: an unmodified opinion supports the figures, a qualified opinion identifies a matter to adjust for, an adverse opinion or disclaimer means the statements cannot be relied on, and a going concern paragraph signals doubt about survival. Reading it first decides how much weight the ratios deserve and what adjustments to make (4 marks).
(b) Any four, two marks each: CR12 (who the directors and shareholders are); register of beneficial owners (who ultimately controls the distributor, and any connection to existing debtors); board resolution (authority to take the credit and sign any guarantee); management commentary (performance, risks and plans in management's own words); credit reference bureau report (repayment history with other lenders); trade references (how promptly it pays other suppliers).