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Financial statement analysis beyond the first glance
Imagine this: you’re a credit analyst tasked with onboarding a potential new customer. After rummaging through a stack of documents, you find what you’re looking for—their balance sheet. At first glance, the company appears to be financially healthy with a positive working capital of $1 million, a current ratio of 2.00:1 and an acid-test (quick) ratio of 1.00:1.
However, after investigating the quality of working capital accounts in days using the cash conversion cycle ratio, the picture becomes considerably less favorable.
This scenario underscores the importance of not accepting what you see at face value. Through a detailed analysis of financials, creditors can quickly identify underlying issues that are not immediately apparent and implement targeted solutions for their customers.
“The objective of financial statement analysis is not simply to determine whether a ratio is good or bad. It is to understand why the ratio changed, what is driving the change and what that change means for the customer’s ability and willingness to pay its obligations,” said George Schnupp, CCE, instructor for NACM’s Financial Statement Analysis 2: Credit and Risk Assessment (FSA2) course.
Performing a more precise analysis
When evaluating financials, credit professionals should first understand that the balance sheet and income statement are interrelated, and that accounting transactions are required to record, or book, a sale. By using standard accounting methods, they can trace how transactions connect to both documents. This requires taking the time to learn how business decisions get recorded in the books.
Recording the sale first requires an examination of credit inventory on the balance sheet and debit cost of sales on the income statement. This is followed by an assessment of debit accounts receivable on the balance sheet and the credit sales on the income statement.
“It is critically important for credit professionals who are just beginning to analyze financials to know that the balance sheet accounts mentioned above flow to the income statement, thus capturing both the investment decision and the operating decision,” said Schnupp.
A deeper analysis can transform what initially appears to be a healthy liquidity position into a more accurate assessment of the customer’s actual credit risk. Financial ratios support informed decision-making by converting financial statement information into measurable indicators of profitability, liquidity, efficiency, leverage, cash flow and overall financial strength. They help credit teams understand how effectively a company operates, how well it generates profits, how efficiently it utilizes its assets, how it finances its operations and how capable it is of meeting its financial obligations.
In conjunction with working capital, the current ratio and the acid-test (quick) ratio should be analyzed together, compared across periods and evaluated based on the quality of the underlying financial information.
However, the most effective credit professionals simply do not analyze financial ratios in isolation. They examine relationships, trends, comparisons, underlying account quality and the reasons for changes from period to period by following a simple process:
- Calculate the ratio
- Understand the trend
- Investigate the cause
- Evaluate the risk
- Make the credit decision
Key skills for financial statement analysis
Apart from mastering financial ratios, credit professionals must be able to interpret that data, identify trends, recognize potential warning signs, ask the right questions and understand how the various components of a company’s financial performance are interconnected.
“A customer may have a strong current ratio, but that doesn’t always mean that they have a lot of cash available,” said Antoine Richardson Jr., CCRA, credit analyst at Helena Agri-Enterprises, LLC (Fresno, CA). “Their current assets could consist of inventory or uncollected accounts receivable. Conducting a deeper evaluation of trends or any other factors that could have impacted these ratios helps me determine an organization’s true financial health.”
This uncertainty demands critical thinking and judgment from credit specialists. “I acknowledge the importance of income statements but being in the agriculture industry, I primarily rely on the balance sheet because there’s so much variation year over year,” said Brint Lindsey, CBA, CCRA, assistant credit manager at Helena Agri-Enterprises, LLC (Collierville, TN). “There are also many external factors that are out of our control that drastically impact a company’s liquidity like severe weather events damaging crops. To ascertain whether my customer will have the ability to pay me, I look at the equity of long-term assets such as real estate or equipment or if they have the receivables or cash on hand to quickly service that debt.”
The bottom line: Ultimately, financial ratios don’t make credit decisions—credit professionals do. Proper assessment of financials paired with critical judgment skills is grounds for reducing exposure and protecting the bottom line.
