Credit Training[Finall]

Credit Training

Dejan JeremićDejan Jeremić

[email protected]

Financial Services

Day 1.

09.45 – 10.00• Welcome10.00 – 11.00• Why & How Financials are used11.00 – 13.00 • Understanding Cash Flow 13.00 – 14.00 (Lunch)14.00 – 18.00• Group Exercises

Day 2.

08.00 – 10:00• Group Exercises10.00 – 13.00 • Example clients13.00 – 14.00 (Lunch)14.00 – 15.00• Wrap-up

Credit Training

Why and How Financials are UsedUnderstanding Financial Statements

• Presented by:

Dejan Jeremić, Regional manager at Volvo Financial Services Financial consultant at HOLD 4 AimBusiness, life and Wingwave coach

Understanding Financial Statements

Section #1

How are Financial Statements used in theLending Decision?

Confidential

Cash Flow Industry

ReviewTime in business

Balance Sheet Review

Pay History

Owners

Collateral Analysis

Affiliates

Income Statement Review

Pricing

Fleet Analysis

Economic Crisis

AML Risk

Deal Structure

Putting the Pieces Together

We are trying to assemble the puzzle pieces to get a clear picture of the firm.

• We are trying to determine if they can, based on the available information, repay the money we lend to them.

• Often, the picture is incomplete because we lack the time to obtain the information, the customer is unable or unwilling to provide the information, or we have not asked for the information.

• Your role as an analyst is to complete as much of this picture as you can so that a committee is convinced that the customer will be able to repay the money we have loaned them.

One Puzzle Piece: Financial Statements

As the financial reports of a business contain a wealth of financial information, it is important to consider why we are analyzing and interpreting the financial reports.

By looking at a financial statement, credit analysts can determine the following:• Is the business profitable? • Does the company have the ability to pay its bills? • Should we loan them money?• What is the capital structure of the business? • How does this year’s financials compare to last year? • How does their financial performance compare with their competitors? • How does the business compare to the industry norms?

Composition of a Financial Statement

1. An Income Statement covering a period of time.2. A Balance Sheet as of the last day in the period of time.

Additional information in a complete financial statement :• A cover letter from the accountant who prepared the statement• Notes to the financial statements• Cash Flow Statement• Statement of the Changes in Retained Earnings

At a minimum, a complete financial statement contains the following items:

Both the Balance Sheet and Income Statement should be from the same time period.

1. An Income Statement for the 12-month period ended December 31, 20082. A Balance Sheet as of December 31, 2008


Section #2

Balance Sheet Structure

Confidential

Balance Sheet: Structure

A balance sheet provides a snapshot, at a SPECIFIC POINT IN TIME, of a firm’s financial position. By financial position we mean:

1. Assets - The quantity of assets the firm has; 2. Liabilities - How much the firm owes to those who

financed those assets; and 3. Equity – After the firm satisfies those who financed its

assets, what is left for the residual owners.

These three items are a snapshot as of a specific day in the year.

Recall our earlier example where we said the Balance Sheet was prepared as of December 31, 2008.

Balance Sheet: StructureFundamental Accounting Equation: Assets = Liabilities + Equity

Assets Liabilities + Equity

Balance Sheet: Structure• What does it mean? The equation that is the foundation of

double-entry accounting. The accounting equation shows that all Assets are either financed by borrowing money (a Liability) or paid for with the money of the company’s shareholders (Equity).

• The balance sheet is a complex display of this equation, showing that the total assets of a company are equal to the total of liabilities and shareholder equity. Any purchase or sale by an accounting entity has an equal effect on both sides of the equation, or offsetting effects on the same side of the equation.

• The equation can be rewritten several ways: Liabilities = Assets - Equity Equity = Assets - Liabilities

Fundamental Accounting Equation: Assets = Liabilities + Equity

Balance Sheet: StructureFundamental Accounting Equation: Assets = Liabilities + Equity

The Fundamental Accounting Equation shows that a company can:

• Fund the purchase of an asset with assets (a $50 purchase of equipment using $50 of cash) or

• Fund it with liabilities (a $50 purchase of equipment by borrowing $50) or

• Fund it with equity (a $50 purchase of equipment by using $50 of retained earnings).

• In the same vein, liabilities can be paid down with assets, like cash, or by taking on more liabilities, like debt.

Balance Sheet - Structure

• Quick Discussion:– What impact does it have on the other financial

statements if the company fund purchases with current assets, loans, or equity?

Example Balance Sheet (U.S.)

Balance Sheet: Assets

The asset portion of the balance sheet is subdivided into:• Current Assets – are cash and assets that are expected to be

converted into cash or used up in the near future, usually within one year.

• Long Term Assets – are assets that will not be converted into cash or used up in within one year.

An entity needs, cash, equipment and other resources in order to operate. These resources are its assets.

Balance Sheet: Current Assets

CashMoney on hand and money in bank accounts that can be withdrawn at any time.

Accounts ReceivableMoney, which is owed to a company by a customer for products and services, provided on credit. It is expected that this current asset will be converted into Cash within 1 year.

Balance Sheet: Current AssetsInventory (Stock)On a balance sheet, the inventory item is the sum of costs of all raw materials, work in process, and finished goods. It is expected that this current asset will be converted into Cash or used up within 1 year.

Prepaid ExpensesWhen companies prepay for goods or services that will be used up within one year, they are classified as a prepaid expense. An example would be paying your annual insurance premium in advance.

Balance Sheet: Long Term Assets

Long Term Assets include Fixed Assets and Non-Current Assets

• Land• Building• Transportation Equipment• Office Equipment• Software

Fixed assets can include:

Balance Sheet: Long Term AssetsIf certain assets accounts cannot be liquidated, in our analysis and presentation of the balance sheet, shouldn’t we “write-down” or reduce the value of these assets? Yes, we should reduce the value of the assets but only when we analyze the Tangible Net Worth. The Balance Sheet must balance. What does this mean?

If a company has 100,000 in Assets, 60,000 in Liabilities and 40,000 in Equity but we learn that 25,000 of the Assets are Goodwill, how would we evaluate the true Equity position of the company.

We subtract the values we cannot liquidate from Equity:

Equity – Intangible Assets = Tangible Net Worth

Tangible Net Worth (“TNW”) is a more accurate measurement of a firm’s true net worth and is often used in place of Equity. Note you do not reduce the Equity account in your extraction. This is an analysis technique. TNW can be used to evaluate leverage, assess risk of default, and structure transactions.

Balance Sheet - Assets

• Quick discussion:

– What impact does a growing A/R have on the cash flow, compared to the balance sheet?

– What impact does the placement of assets as Current or Long Term have on the cash flow?

Balance Sheet: Current Liabilities

Like Current Assets, Current Liabilities are usually repaid within 1 year. Examples of current liability accounts include but are not limited to:

• Line of Credit Balances (Revolving and Non Revolving)• Current Portion of Long Term Debt Balances (CPLTD)• Accounts Payable, and Accruals.• Other Current Liabilities

Balance Sheet: Current LiabilitiesLine of Credit (LOC)

Lines of credit extended by banks and other lending institutions usually provide the company with short term liquidity to meet its operating needs. These lines can be structured in any number of ways but generally are renewed annually. Sometimes they revolve. Sometimes they don’t revolve.

Let’s discuss the following items that relate to lines of credit:• How is it similar to a Credit Card?• Repayment and the Impact on Cash Flow• Secured versus Unsecured• Borrowing Base • Availability and Utilization• Financial and Non Financial Covenants

It is imperative that LOC are not included with term debt when extracting financial statements.

Balance Sheet: Current Liabilities Continued

Accounts PayableMoney which a company owes to vendors for products and services purchased on credit. It is important that you not include any other accounts besides Accounts Payable in the financial extraction report.

AccrualsOn accrual based statements, the Company records expenses when they arise not when they are paid. When you see accrual, think “owed but not yet paid”.

Examples of Accrued Expenses:• Income taxes• Payroll• Interest

Balance Sheet: Current Liabilities Continued

Current Portion of Long Term Debt (CPLTD)

On the Balance Sheet, the principal that is to be repaid within the next 12 months is listed in the CPLTD account.

Example: $6.0MUSD note. 0% interest. No Balloon at the end of the term. 60 equal payments of principal.

The current portion of long term debt would be:$6.0MUSD / 5 = $1.2MUSD

The Long Term portion would be: $6.0MUSD - $1.2MUSD = $4.8MUSD

It is imperative that CPLTD is distinguished from long term debt when extracting financial statements.

Balance Sheet: Long Term Liabilities

The portion that does not have to be repaid within 12 months is listed in the Long Term Debt (LTD) account in the Long Term Liability section of the balance sheet.

We introduced the concept that debt that does not have to be repaid within 1 year is considered long term. The liabilitysection of the balance sheet contains several accounts, that can include term debt, that do nothave to be repaid within 1 year. These accountscan vary but all are considered long term liabilities.

Balance Sheet: Long Term Liabilities

Examples of Long Term Liabilities include but are not limited to:

• Long Term Debt• Subordinated Debt• Deferred Income

Contingent Liabilities and Off Balance Sheet Financing

Contingent Liabilities and Off Balance Sheet Financing are similar in that neither item is included among Current or Long Term Liabilities on the Balance Sheet. If you have an audited financial statement, it is fairly easy to determine whether or not a firm is contingently liable by reading the notes to the statements. Otherwise, you must interview the customer to discover this. An example of contingent liability would be if our firm guaranteed another party’s debt. In the event that party defaults, our firm becomes contingently liable for the debt. Off Balance Sheet financing often takes the form of operating lease debt or rentals. This information appears on the incomestatement.

It is imperative that we extract this information in our analysis because it impacts our understanding of leverage & cash flow coverage.

Balance Sheet: EquityEquity consists of:

1. Common Stock, an equity security that represents ownership in a corporation. (or preferred stock, not discussed here)

2. Paid-in Capital - Funds obtained from equity investors who are owners

3. Retained Earnings resulting from the entity’s profitable operations. The accumulated profits of a company. These may or may not be reinvested in the business.


Section #2-2

How to analyze the Balance Sheet

Confidential

Balance Sheet: Accounts Receivable DOH

*Ideally we should use Average A/R to calculate this formula. A/R Days on Hand (“abbrevieated “DOH”) indicates how quickly a company collects cash from customers that owe it money; i.e how long it takes to covert A/R to Cash.

The sooner it is collected, the sooner the company can put it to work to purchase more inventory or to pay for current orders. It is helpful in analyzing the collectability of receivables, or how fast a business can increase its cash supply.

Although businesses establish credit terms, customers do not always adhere to them. In analyzing a business, you must know the credit terms it offers before determining the quality of receivables. While each industry has its own average collection period (number of days it takes to collect payments from customers), there are observers who feel that more than 10 to 15 days over stated terms should be of concern to you.

When extracting A/R for analysis, no other assets should be included on the line item.

A/R*Sales x 365 = A/R DOH

Balance Sheet: Accounts Receivable DOH

Whether or not payments are being collected in a timely manner Perform an A/R Aging analysis in order to indentify customer

concentrations which also Allow you to identify which customers they are having collection

problems with.

You can supplement the analysis of A/R DOH by also reviewing the firm’s Accounts Receivable Aging Report. Again, ideally we should calculate A/R DOH using average A/R but this is very difficult to do in practice. We want average A/R because A/R on a specific balance sheet date might not reflect the average A/R the firm carries (due to seasonality) which in turn may skew our understanding of how timely they collect A/R.

An A/R Aging Report allows us to directly view:

Balance Sheet – A/R DOH

• Discussion item:– Can a client who has A/R DOH of 70 days have

no overdue receivables?– Why do we care when the A/R DOH is in an

increasing trend?

Balance Sheet: Accounts Payable Turnover

*Ideally, we should use average A/P for the same reasons as given for the first two ratios.

Accounts Payable DOH measures how the company pays its suppliers in relation to the cost of sales (or Sales when COGS not available) volume being transacted.

A low payable turnover would indicate a healthy ratio. Conversely, a high payable ratio could mean the company must delay payments beyond granted terms in order to preserve Cash. Like A/R DOH, you should know the credit terms the firm was granted by its supplier to put this ratio into the proper context. Figures significantly higher than credit terms should be addressed in your presentation as well as significant swings in the figure period over period.

A/P*COGS x 365 = A/P DOH

Balance Sheet: Working Capital and Liquidity

Working Capital is a measure of both a company's efficiency and its short-term financial health. Many lenders use working capital to determine a firm’s liquidity….or how easily its Current Assets can be converted into Cash which in turn is used to cover its Current Liabilities.

The more liquid the assets are the higher the probability they can cover current liabilities. Illiquidity is a risk that a company might not be able to convert its assets into Cash when most needed and in turn, not be able to cover Current Liabilities.

Moreover, having to wait for the sale of an asset can pose an additional risk if the price of the asset decreases while waiting to liquidate.

Working Capital is the Difference between Current Assets and Current Liabilities.

Working Capital = Current Assets – Current Liabilities

Balance Sheet: Working Capital & LiquidityWorking Capital can either be expressed as the difference between Current Assets and Current Liabilities or the Working Capital Ratio which can be expressed as Current Assets divided by Current Liabilities. The common name for the Working Capital Ratio is the Current Ratio.

Current Ratio = Current Assets

Current Liabilities

Example: If a firm has $100,000 in current assets and $80,000 in current liabilities

Its Working Capital is $100,000 - $80,000 = $20,000. If for some reason, all current liabilities were due and payable today, the firm could cover its current liabilities with an additional $20,000 to fund short term operations

Its current ratio would be ($100,000 / $80,000) = 1.25 to 1.00. What does a current ratio of 1.25 mean? How can you use it in your analysis?

Tip: Ratios are useful because they are a relative measurements which can be used to compare a firm to its peers as well as to its past performance in order to analyze the trend.

Balance Sheet: Working Capital and Liquidity

• Positive working capital means that the company is able to pay off its short-term liabilities by liquidating its current assets. Negative working capital means that a company currently is unable to meet its short-term liabilities with its current assets (cash, accounts receivable and inventory).

• If a company's current assets do not exceed its current liabilities, then it may run into trouble paying back creditors in the short term. The worst-case scenario is bankruptcy. A declining working capital ratio trend over a longer time period could also be a red flag that warrants further analysis.

• If this trend is observed when the financials are extracted, it should be addressed in your presentation.

Balance Sheet: LeverageThe leverage ratio (known as Gearing in the UK) is a financial ratio indicating the relative proportion of equity and debt used to finance a company's assets.

Leverage = Total Liabilities

Equity

Leverage is a relative measure of a company’s risk of default. This ratio indicates the amount due to creditors within a year as a percent of the owner’s investment. Companies with high leverage (i.e. have higher Total Liabilities relative to Equity) have a higher risk of defaulting on their obligations to their creditors.

Normally, a business starts to have trouble when this relationship exceeds 80%. (Alternatively, this number may take the format of 8x pronounced “Eight Times”….as in Liabilities are eight times tangible net worth).Leverage less than 1x is considered nominal and less than 2x is considered low.Leverage less than 3x is considered moderately low.Leverage from 4x to 7x is considered moderately high.Leverage in excess of 8x is considered extremely high.

Balance Sheet: Leverage ContinuedThe leverage ratio should be compared to peer firms within the same industry.

Example: If a firm had $500,000 in Total Liabilities, $300,000 in Net Worth, what would its leverage be?

Leverage = Total Liabilities / EquityLeverage = $500,000 / $300,000 = 1.6 to 1.00

Is this company highly leveraged?

Balance Sheet: Contingent Liabilities and Off Balance Sheet Financing

In the last example we determined that the leverage ratio was 1.6 to 1.0 based on the total liabilities of $500,000 and $300,000 in Net worth.

What if the same company also had other off balance sheet commitments?

Example: $1.5 million in operating leases. How would the leverage calculation change?

Leverage = (Total Liabilities + Off Balance Sheet Commitments)/ EquityLeverage = ($500,000 + $1,500,000) / $300,000 = 6.6 to 1.00

Is this company highly leveraged if you consider this off balance sheet commitment?

Does your opinion of the company’s financial position change? Are the risks of the company defaulting on its loan agreements greater or smaller?

Balance Sheet - Leverage

• Discussion item:– Why do you think that customers who are highly

leveraged tend to default more?

• Food for thought:– Equity in a company is like the down payment on

an asset. The more that a person has invested relative to the total worth, the more that they will want to retain that investment.

Balance Sheet A/R Types 2007 2008

Normal Trade MTHB 336 MTHB 548

Hire Purchase MTHB 115 MTHB 160

Balance Sheet Comments:

1) Trade Receivables are categorized as;

Normal Trade A/R increased sharply because of PT Thailindo equipment were shipped and invoiced in Aug 2008 which will receive the money in Dec 2008. They also provide hire purchase facility to end customers themselves which the A/R also increased sharply.

2) Total Current Assets also includes Inventory of MTHB 649.72 in 2007 and MTHB 640.84 in 2008.

3) Intangible Assets increased by 45% mainly due to the increase in Hire purchase Receivables (from MTHB 58.20 to MTHB 127.33) and the decrease in Assets for Rent (from MTHB 217.22 to MTHB 171.28).

4) As of Aug 2008, Working Capital utilization rose by 144% due to an increase in bank overdraft and trust receipts for imported products (non-Volvo brand). Facilities comprises of Bank overdraft (MTHB 16.94) and Trust receipt (MTHB 102.02).

5) CPLTD has been increasing since 2006 as ITI started floor plan financing with VFS, Krungthai IBJ and Cathay Lease Plan.

6) Intercompany payable in 2007 and 2008 of MTHB 174.80 (repayable on demand and unsecured) consists of 3 related parties which are Italthai Holding (MTHB 46.80) Sakdi Sin Prasit Co., Ltd (MTHB 10.00) and Director (MTHB 118.00).

7) Long-Term debt dropped by 91% to MTHB 4.10 because the equipment under financing was sold to end customers.

8) Accumulated deficit in Retained Earnings was carried over from 1997 to 2007 due to the financial crisis in 1997. But with profitability generated in the last few years, it managed to recover and reported a positive earnings of MTHB 17.90 in Aug 2008.

9) Trade receivables turnover increased from 51 days in 2007 to 86 days as of Aug 2008 mainly due to PT Thailindo deal which was pending VFS financing, but has already been paid in Dec 2008.

10) For contingent liability for PT Thailindo, ITI has not yet decided how to categorize the guarantee in the financial statement and still waiting for management’s final decision.


Section #3-1

Structure of the Income Statement

Confidential

Example Income Statement (U.S.)

Income Statement

Definition:While the Balance Sheet is a statement of financial condition at one point in time, the Income Statement shows what revenues were earned and what expenses were incurred OVER A PERIOD OF TIME.

The primary purpose of the income statement is to report the profitability of the business in relation to revenues; however it can also reveal important insights into how effectively and efficiently management is controlling expenses.

Income StatementAs an analyst, you should use the income statement to ask management questions like:

Are Revenues growing, shrinking, or staying the same and specifically, “Why?” How are revenues earned? What percentage does each of their customers contribute to total revenues? How long have they had relationships with each of these customers? Are the relationships based on contracts? Can I review the contracts? What lines of business or divisions is the company engaged in…how do they make money?

How much does each line of business or division contribute to total revenues? How has this changed year to year? Do they earn money outside of providing transportation services, construction services; etc.?

How much revenue does one revenue-generating asset contribute to annual sales? Monthly sales? Based on kilometers driven or hours used, can you calculate what the revenue generated per kilometer.

Does this historical revenue generating information tie to what management says the new equipment will produce?

Income StatementStructure: Balance Sheets note the “as of” date and an Income Statements note

the period of time covered by the statement (1 month, 9 months, 12 months, etc.); otherwise, there is no point of reference to understand the information in the statement.

It’s important to note that not all income statements look alike but they necessarily contain much of the same information.

An Income Statement has a specific structure. It starts with Revenues for the period (Top Line), lists the expenses of the period, and generally ends with Net Income (Bottom Line)

Income StatementTyson Foods Inc.

Fiscal Year ended 2005 (Millions of USD)Top Line

Bottom Line

To understand structure and meaning of every “Element of the Income Statement” we are going to review “Tyson Foods Inc” Income Statement 2005

a) Sales 100 26,014$ (+)b) Cost of Sales 80 24,294$ (-)c) Gross Profit 20 1,720$ d) Operating expenses 10 975$ (-)e) Operating Profit 10 745$ f) All Other income & expenses 1 10-$ (-)g) Interest Expense 5 227$ (-)

Margin before taxes 4 528$ Taxes Expense 1 156$ (-)

h) Net Income 3 372$

Income Statementa) Sales

Sales $ 26 014This figure is the amount of Revenues a business brought in during the time period covered by the Income Statement. It has nothing to do with profit.Many companies can break sales up into categories to clarify how much was generated by each division.Defined and separate revenue sources can make analyzing an income statement much easier.

Income Statementb) The Cost of Sales

It represents the cost of producing the products sold. It can include:

• Raw materials• Labor force• Overhead associated to production • Sometimes Depreciation/Amortization but this account can also be included in

the operating expenses (to be analyzed)

Service based companies generally do not register cost of sales.

Income Statementc) Gross Profit

The gross profit is the total revenue subtracted by the cost of generating that revenue.

a) Sales: 26,014$ b) Cost of Sales 24,294$ c) Gross Profit 1,720$

Income Statemente) Operating IncomeThe difference between Gross Margin and Operating Expenses give us the Operating Income, which is a measurement of the money a company generated from its own operations. It can be used to check the health of the core business

a) Sales 26,014$ b) Cost of Sales 23,793$

501$ c) Gross Profit 1,720$ d) Operating expenses 975$ e) Operating Income 745$

Depreciation

Income Statementf) All other income or expenses These will arise when non-recurring items or events occur and are not expected to occur again, examples:• Sale of fixed assets such as machinery, transport units, etc.• Legal Claims• Improvement to facilities


501$ c) Gross Profit 1,720$ d) Operating expenses 975$ e) Operating Income 745$ f) All Other income & expenses 10-$

Depreciation

Income Statementg) Interest Expense

Some income statements report interest income and interest expenseseparately, while others report interest expense as “Net”. Net refers to: Net Income-Net ExpenseInterest Income: Companies sometimes keep their cash in short-termdeposit investments, the cash placed in these accounts earn interest for

thebusiness, which is recorded on the income statement as interest income. Interest Expense: Cost of Borrowing

It is imperative that we extract Interest Expense in order to understand the Company’s ability to cover its interest costs.

Income Statement


501$ c) Gross Profit 1,720$ d) Operating expenses 975$ e) Operating Income 745$ f) All Other income & expenses 10-$ g) Interest Expense 227$

Margin before taxes 528$

Depreciation

The amount of interest a company pays in relation to its revenue andearnings is tremendously important because this task can be the difference between a positive or negative result.

Income Statement


501$ c) Gross Profit 1,720$ d) Operating expenses 975$ e) Operating Income 745$ f) All Other income & expenses 10-$ g) Interest Expense 227$

Margin before taxes 528$ Taxes Expense 156$

h) Net Income 372$

Depreciation

i) Net Income

This is the bottom line, which is the most commonly used indicator of acompany's profitability. Of course, if expenses exceed income, this account will read as a net loss.


Section #3-2

How to analyze an Income Statement

Confidential

Income Statement AnalysisWhat is important of the information that we are reviewing?

Ratios for the Income Statement

• Sales Growth• Gross Profit Margin• Operating profit margin• Net Profit Margin

• EBIT• Interest coverage ratio: EBIT ÷ Interest Expense• EBITDA• EBITDA Margin• EBITDAR

On the following slides, (F) denotes formula and (E) denotes example

Income Statement Analysis Sales Growth is one of the key measurements an analyst will review.

Sales growth is measured by comparing sales figures from two periods oftime. Ideally, the sales figures should cover equal amounts of time,otherwise, the analyst must make an adjustment.

(F) Sales (current period) – Sales (prior period) Sales (prior period)

(E) 26,014 – 26,441 26,441

= - 0.016 x 100 = -1.6%

An analyst should ask management about any large increases in Sales Growth. He should also ask questions if Sales volume is unchanged from the prior period or if Sales have declined. He should ask about erratic trends.

Income Statement Analysis

2003 2004 2005

Sales Growth 16.3% 35.1% 32.2%

Gross Profit Margin 22.8% 23.3% 23.4%

Operating Margin 2.9% 4.0% 5.1%

Net Margin 1.44% 1.96% 2.63%

With multiple financial statements, you compare many of the ratios to determine what direction your company is headed in. Here are some key ratios over a 3 year time frame for a real private traditional trucking operation from our records. What would you say about the financial trends of this company?

Income Statement AnalysisEarnings Before Interest and Income Taxes (“EBIT”)

EBIT measures of a firm’s profitability and management’s efficiency at minimizing operating costs. It excludes interest and income tax expenses. You will see EBIT and Operating Profitability used interchangeably.

Technically speaking, EBIT and Operating Profitability are only equal if a firm does not have any Non-Operating Income. If a firm has significant sources of non operating income and you use Operating Profitability as a measure of profitability, you will underestimate when looking at the income statement and underestimating their ability to cover interest and amortize debt when looking at interest coverage ratios and Cash Flow.

Net Sales $20 438 Cost of goods sold $7 943Gross Profit $12 495

Selling, general and administrative expenses $8 172 Depreciation and amortization $960 Other expenses $138 Depreciation and Amortization $960 Other Expenses $138

Total operating expenses $9 270Operating income $3 225 Nonoperating income $130Earnings before interest and income taxes (EBIT) $3 355 Net interest expense $145Earnings before income taxes $3 210 Income taxes $1 027Net income $2 183

Statement of Income — Example(figures in millions)

Operating Revenues

Operating Expenses

Income Statement AnalysisEarnings Before Interest and Income Taxes (“EBIT”)

It can be calculated several ways but the result is the same:Net Sales – COGS – Total Operating Expenses (OPEX) + Non-Operating Income.

20438 – 7943 – 9270 + 130 = 3355

**************************OR********************************

Operating Income + Non-Operating Expenses

3225 + 130 = 3355

**************************OR********************************

Net Income + Interest Expense + Taxes

2183 + 145 + 1027 = 3355

Net Sales $20 438 Cost of goods sold $7 943Gross Profit $12 495

Selling, general and administrative expenses $8 172 Depreciation and amortization $960 Other expenses $138 Depreciation and Amortization $960 Other Expenses $138

Total operating expenses $9 270Operating income $3 225 Nonoperating income $130Earnings before interest and income taxes (EBIT) $3 355 Net interest expense $145Earnings before income taxes $3 210 Income taxes $1 027Net income $2 183

Statement of Income — Example(figures in millions)

Operating Revenues

Operating Expenses


EBITDA measures the cash earnings that may be applied to interest and debt retirement. Like EBIT, EBITDA measures how efficiently the company is operated which in turn is an indicator of how profitable it is. It is a good indicator of how much Cash is generated by the company’s operating activities which is why we use it in Cash Flow Analysis.Depreciation and Amortization Expense do not signify a Cash Outlfow. The Cash Outflow occurred when the Fixed Asset or Intangible Asset was acquired. See slide #134. As a lender, we ignore depreciation and amortization because they are non-cash charges and thus do not interfere with a company's ability to repay debt. If you omit them from your financial extraction, you negatively impact our understanding of the company's ability to repay debt.

Additionally, such figures are merely a reconciliation of cash-basis accounting to accrual-basis accounting and are subject to a certain degree of flexibility corporate accountants have when setting depreciation and amortization schedules.

Earnings Before Interest and Income Taxes Depreciation and Amortization (“EBITDA”)


EBITDA Margin is a financial metric used to assess a company's profitability by comparing its revenue with earnings. More specifically, since EBITDA is derived from revenue, this metric would indicate the percentage of a revenues remaining after operating expenses.

For example, if XYZ Corp's EBITDA is $1 billion and its revenue is $10 billion, then its EBITDA to Sales ratio (EBITDA Margin) is 10%. Ten out of every one hundred dollars of revenues earned is retained and is available to service debt.

Generally, a higher EBITDA Margin indicates that the company is able to keep its earnings at a good level via efficient processes that have kept certain expenses low.

EBITDA Margin = EBITDA

Sales


Sales=

$1 billion

$10 billion= 10%


Because EBITDA margin is a good measure of how efficient a firm is at keeping expenses low and because it is a relative measurement of efficiency, it can be used in a variety of ways which include:Comparing several periods, you can determine if a firm is becoming more or less

profitable (efficient) over time. It is used on the Quick and Dirty Financial Statement Analysis Tool as a way to

project EBITDA. This projected EBITDA is used to calculate a firm’s ability to service new and existing debt. (Cash Flow Projection Analysis).

It can be used to compare a firm to another firm within one industry. However, when comparing company's EBITDA margin, make sure that the companies are in related industries as different size companies in different industries are bound to have different cost structures, which could make comparisons irrelevant.


Sales

Income Statement

Depending on the company and the goal of the user, EBITDAR can either include restructuring costs or rent costs, but usually not both. The EBITDAR indicator expands on EBITDA by adding an additional excluded item to give a better indication of financial performance.

Rent is included in the measure when evaluating the financial performance of companies, such as trucking companies that have significant rental and lease expenses derived from business operations.

By excluding these expenses, it is easier to compare one trucking firm to itself over time which allows an analyst to determine if they are more or less efficient, period-over-period. You can also compare one company to another and get a clearer picture of their operational performance relative to their peers.

Earnings Before Interest and Income Taxes Depreciation and Amortization and Rental or Restructuring Costs (“EBITDAR”)

Income Statement EBITDAR - Continued

Tip: When the company has not had any rental or restructuring costs, you use the EBITDA figure. In fact, EBITDA and EBITDAR are equal when there is either no rental or restructuring costs listed among the operating expenses.

Tip: When a company has rental costs (like renting transportation or construction equipment), use EBITDAR as the measurement of profitability and the EBITDAR cash flow model to measure historical and projected ability to service debt.

Restructuring is included in the measure when a company has gone through a restructuring plan and has incurred costs from the plan. These costs, which are included on the income statement, are usually seen as nonrecurring and are excluded to give a better idea of the company's ongoing operations.

Both EBITDA and EBITDAR ratios and cash flow calculations are included in the Quick and Dirty Financial Statement Analysis Tool.

Income Statement Comments:

1) As of Aug 2008, Revenue growth is relative flat at 0.1% based on annualized basis compared to last year. Despite the weak economic conditions, the company is still able to maintain its business volume.

2) Based on annualized basis, Depreciation & Amortization for Aug 2008 and Dec 2007 are remained in the same level at MTHB 122.82.

3) For year 2004 and 2005, no corporate income tax were paid on the profit since the company has been granted income tax privileges from 1999 to 2005.

4) As of Aug 2008, Net Profit shown only MTHB 33.84 due to the exchange rate loss for importing the equipment for PT Thailindo deal. Despite an increase in operating expenses, PT Thailindo deal which was booked during Q4 2008 will increase ITI’s Net Income from 33.84 in Aug 2008 to an expected Net Income of MTHB 45.00 in Dec 2008.

5) The company remains profitable in the past 5 years.

Income Statement –

Income Statement

• Quick Discussion:– What does it mean when a company has gone

through a restructuring? Is that the same thing as our loan restructure?

Understanding Cash Flow

Section #4-1

Cash Flow Statement

Confidential

Cash Flow Statement Construction and Analysis

In order to construct a valid cash flow, not to mention analyze the balance sheet and income statement ratios, you must accurately extract all the relevant financial data from your financial statements.

DO NOT RESTATE THE FINANCIAL STATEMENT FIGURES THEY PROVIDE IN YOUR EXTRACTION WITHOUT ANALYZING THEM! Recall that throughout this presentation we have emphasized the importance of extracting all the appropriate balance sheet and income statement items. A proper financial statement extraction takes into account many variables, regardless of local accounting standards. In doing so, you standardize the format of the financial statement for our internal needs and allows you to more objectively evaluate the financial condition of the customer.

Here is a recap of what we discussed and why it is important to extract these items:


Extract Depreciation and Amortization Expense as these are non-Cash expenses. These expenses are normally found among the firm’s operating expenses on the Income Statement but occasionally they are listed among the Cost of Goods Sold. If not found on the Income Statement you should:

Unless the firm has fully depreciated all its fixed assets, there should be Depreciation Expense listed in your financial extraction. If you omit Depreciation Expense, you negatively impact our understanding of whether or not the customer generates enough Cash to service historical and projected debt.

Look at the Statement of Cash Flows for this informationLook at the notes to the financial statements for this informationEstimate the number by subtracting Accumulated Depreciation from the Current

Period from the Prior Period (See Slide #135…the difference in Accumulated Depreciation between Year 1 and Year 2 is Equal to the Depreciation Expense for the period) or

Ask management (See Next Slide)


If you ask management about the location and amount Depreciation and Amortization Expense, pay close attention to the way they answer the question. Your first question should be: “Are Depreciation Expense and Amortization Expense buried among the expenses on the Income Statement or have they been excluded?”

“If the answer is “Yes, depreciation and amortization are included in the expenses on the Income Statement” then your follow up question should be “What are the exact amounts of depreciation and amortization?” Companies that don’t know what these figures are demonstrate that they have poor internal accounting controls in place. You should take the information they provide and show it when you extract the financial statements. Extracting depreciation and amortization will not affect Net Income since these figures were previously buried among the existing expenses but will positively affect the calculation of Cash Flow. In your extraction, be sure to reduce other expenses so that Net Income is unchanged.

If the answer is, “No, depreciation and amortization are not included on this statement” you should ask “Have your fixed assets have been completely depreciation and have your intangible assets, such as Goodwill, been completely amortized?” If they have been fully depreciated and amortized, then your investigation is complete and you should mention this in your presentation. If not, find out what the numbers are and extract these items. This will reduce Net Income by the amount you input but will not effect Cash Flow.

Why?


If expenses have been inflated to reduce profitability you should investigate what expense items were inflated and what the net effect was on profitability.

If cash actually flowed out of the business, then these were real, cash expenses so this money is not available to service existing debt or amortize new debt. No adjustments to your extraction are required.

If cash did not flow out of the business, then these were non-cash expenses akin to Depreciation and Amortization. Additional adjustments to your extraction are required. I recommend categorizing these types of expenses as Depreciation and Amortization because they are non-Cash expenses. By this, you won’t change Net Income but you will give a clearer picture of the company’s ability to service debt.


Rentals signify significant off-balance sheet financing. Operating equipment leases are an example of off balance sheet financing. Used in calculation of off balance sheet financing which impacts the calculation of

operating leverage. Used in the calculation of EBITDAR which can significantly impact our

understanding of their ability to service existing and newly proposed debt.

Interest Expense should be extracted as it is an important factor in the calculation of EBIT, EBITDA, EBITDAR as well as calculating interest coverage ratios and EBITDA Margin.

Contingent Liabilities such as guarantees of another party’s debt should be noted and leverage recalculated to address these items. You should also address the Company’s ability to service this debt if a lender requires them to do so.

You should only include A/R, Inventory, Lines of Credit, CPLTD, LTD, A/P, etc. on line items designated for them in the extraction report. Including other accounts skews the financial statement analysis.


A few additional questions you will need to answer to construct your cash flow and projection are:

Is the equipment the firm wishes to finance, expanding their existing fleet or replacing equipment in their fleet?

If they are expanding, you should treat the annual principal and interest payments as additional debt service in your analysis.

If they are replacing equipment…i.e. ending one note and starting another and if the payments are similar, you do not have to consider this as additional debt service.

If they are replacing equipment but the equipment being replaced has not had any outstanding notes against it for over a year or more, then this is still additional debt service.


Once you have satisfied yourself that you have extracted the data in the financial statements correctly, that you understand the answers management has provided you, and you know whether or not you are looking at additional debt service or replacement debt service, you are ready to analyze the financial statements and construct a Cash Flow Statement.

Luckily, you can use spreadsheets to automate this process so it is unnecessary to do this by hand. I do recommend that at some point, you sit down with a calculator and see if you can recreate the calculations in the spreadsheet.

Example of Accountant Prepared Cash Flow Statement (U.S)

Cash Flow Statement

Definition:

A cash flow statement is a financial report that shows incoming and outgoing cash during a specific period of time. The statement shows how changes in balance sheet and income accounts affected cash and cash equivalents.

Why is this Statement important?

As an analytical tool the statement of cash flows is useful in determining the short-term viability of a company, particularly its ability to pay bills.

Cash Flow Statement

Recall the example U.S cash flow statement. It is comprised of 3 sections which is one typical format of a Cash Flow Statement*:

• Cash provided (used) by operating activities

• Cash provided (used) by Investing activities

• Cash provided (used for) financing activities

*Be aware that there are many Cash Flow formats but we will not cover them in this class.

Many publicly traded companies provide Cash Flow Statements in addition to the Balance Sheet and Income Statement. This document provides aggregate data regarding all cash inflows a company receives from both its ongoing operations and external investment sources, as well as all cash outflows that pay for business activities and investments during a given period.

Cash Flow StatementBecause public companies tend to use accrual accounting, the income statements they release may not necessarily reflect changes in their cash positions. For example, if a company lands a major contract, this contract would be

recognized as revenue (and therefore income), but the company may not yet actually receive the cash from the contract until a later date.

While the company may be earning a profit in the eyes of accountants (and paying income taxes on it), the company may actually end up with less cash than when it started the period.

Even profitable companies can fail to adequately manage their cash flow, which is why the cash flow statement is important: it helps lenders see if a company is having trouble with cash.

Cash Flow StatementSo, if the accountant prepared cash flow statement provides all this information, the logical question is: “Why do I need to construct another Cash Flow Statement? Isn’t this duplicating their efforts? Why is this necessary?”

Cash Flow Statements primarily show the sources (inflow) and uses (outflow) of Cash.

Depending on the Cash Flow Format used by the customer, it is not always apparent if, on a historical basis, they generated enough Cash to service debt.

Additionally, depending on the Cash Flow Format used by the customer, it may be difficult to take their format and manually project if they can service the new debt being proposed.

Because of these difficulties, many lenders use an alternative to the customer’s Cash Flow Statement format to analyze how debt was serviced and if they are capable of generating enough Cash to service the newly proposed debt.

Alternative Cash Flow FormatsThere are numerous alternative Cash Flow formats but we will focus on two the simplest to construct: Basic Cash Flow and EBITDA Cash Flow

Basic Cash Flow (abbreviated “BCF”)

Use this method to make a quick assessment of the customer’s historical ability to service debt. It can be done in your head while sitting in front of the customer.

*(pp) means Prior Period.

BCF = Net Income + Depreciation + Amortization If BCF>0 this is positive; If BCF < 0 this is negative

Surplus or (Deficit) BCF = Net Income + Depreciation + Amortization – CPLTD (pp)*

Positive results indicates there is surplus BCF; Negative results indicate is there is insufficient BCF.

BCF Coverage = (Net Income + Depreciation + Amortization) / CPLTD (pp)

If > 1, BCF exceeds existing Debt Service; If < 1, Existing BCF does not cover existing Debt Service.

Alternative Cash Flow: Basic Cash FlowThe Values in the adjacent chart are in $1,000s of USD.

Using CPLTD (pp)1. What is the basic cash flow

coverage for 2003 – 2006?

2. What is the surplus (or deficit) basic cash flow?

3. What trend do you see?

4. Compare the BCF trend to the profit trend. What is the difference?

5. What questions would you ask management?

Sample Trucking CompanyStatement Date 12/31/03 12/31/04 12/31/05 12/31/06Months Covered 12 12 12 12

Revenues $25,601 $32,253 $42,337 $44,019Revenue Growth % 0.00 25.98 31.27 3.97Depreciatin Expense $2,205 $2,818 $3,996 $4,618Operating Margin % 8.20 3.30 2.23 -1.54Operating Ratio % 91.80 96.70 97.77 101.54EBITDA $4,213 $4,055 $5,084 $4,616EBIT $2,008 $1,237 $1,088 -$2Interest Expense $663 $759 $1,062 $1,113Net Income $876 $313 $36 -$782Dividends $0 $0 $0 $0

Cash & Equivalents $19 $0 $1 $1Total Current Assets $2,955 $4,145 $4,627 $4,472Total Assets $14,582 $19,585 $20,980 $21,528Goodwill $0 $0 $0 $0CPLTD $3,123 $3,602 $3,253 $4,049Total Current Liabilities $5,453 $7,747 $7,231 $7,407Total Liabilities $11,140 $15,830 $17,273 $18,603Contingent LiabilitiesEquity $3,442 $3,755 $3,707 $2,925TNW $3,159 $3,418 $3,300 $2,925

Current Ratio 0.54 0.54 0.64 0.60EBIT/Interest 3.03 1.63 1.02 0.00EBITDA/(Interest+CPLTD) 1.11 0.93 1.18 0.89Total Liabilities/TNW 3.53 4.63 5.23 6.36(Total Liabs+Cont. Liabs)/TNW 3.53 4.63 5.23 6.36

BCF compared to CPLTD (pp) is the simplest way to evaluate a firm’s ability to service historical debt. It can be done in your head or with a calculator while visiting a customer. If you see negative trends, you can ask the customer about them immediately.

BCF compared to CPLTD from the prior period is the most accurate way to evaluate a firm’s ability to service debt. Recall that CPLTD from the balance sheet represents principal on debt a company must repay within the next 12 months. It makes sense that we use the CPLTD from the prior period because it is due in the current period.

Example: CPLTD as of December 31, 2008 must be repaid between January 1, 2009 and December 31, 2009. Therefore, we compare it to BCF generated in 2009.

Alternative Cash Flow Formats

One small problem with using CPLTD (pp) is that you cannot analyze cash flow coverage with only one period of data. Additionally, as an analyst, you may want a more conservative calculation, especially if the company is growing rapidly or during times of economic crisis. In this case, you may want to use CPLTD from the current period (CPLTD (cp)).

If a company acquires revenue generating assets on December 31, 2008 on credit, principal and interest payments start and will continue through 2009. The revenues the assets will generate should start in 2009. It would not be accurate to compare the revenues generated in 2008 to the principal and interest payments on these assets but it would be conservative. Why?

If you calculate positive cash flow coverage and excess surplus cash flow using this conservative method, you can be fairly certain that on a historical basis, the company’s cash flow is strong.

Alternative Cash Flow Formats

Alternative Cash Flow: Basic Cash Flow

Using Prior Period (pp) CPLTD

2003 2004 2005 2006Net Income 876 313 36 -782Depreciation 2205 2818 3996 4618

BCF 3081 3131 4032 3836

CPLTD (pp) n/a 3123 3602 3253BCF Coverage n/a 1,00 1,12 1,18

Surplus (Deficit) BCF n/a 8 430 583

Net Profitability Trend n/a Negative Negative NegativeBCF CoverageTrend n/a n/a Positive Positive

Using Current Period (cp) CPLTD

2003 2004 2005 2006Net Income 876 313 36 -782Depreciation 2205 2818 3996 4618

BCF 3081 3131 4032 3836

CPLTD (cp) 3123 3602 3253 4049BCF Coverage 0,99 0,87 1,24 0,95

Surplus (Deficit) BCF -42 -471 779 -213

Net Profitability Trend n/a Negative Negative NegativeBCF CoverageTrend n/a Negative Positive Negative

Using CPLTD (pp) Using CPLTD (cp)

Alternative Cash Flow: Basic Cash FlowSample Trucking CompanyStatement Date 12/31/03 12/31/04 12/31/05 12/31/06Months Covered 12 12 12 12




Notice that our financial statement covers 12 months of data in each period. This makes our calculations simple.

What if the numbers in the last column only represented 9 months of data instead of 12?

How would we adjust our BCF formula? Would your opinion of the financials change?

The Values in the adjacent chart are in $1,000s of USD.

We would need to adjust (or ANNUALIZE) our formula so that we are comparing 12-months of basic cash flow to CPLTD that has to be repaid in 12 months.

In our example on the previous slide, the accounts in the last column only represent 9 months of data instead of 12. We must annualize this data to construct our cash flow. Recall that the figures are in $1,000s of USD.

The firm’s Net Loss for the first 9 months of 2006 was = (782K) Annualize the Net Loss by dividing it by 9 months and multiplying the result by 12 months.

(782K) / 9 months = (86,9K). They lost, on average, 86,9 K per month for the first 9 months of 2006.

(86,9K) x 12 months = (1042,7K). They are projected to lose 1042,7K during the 12 months ended December 31, 2006.


Repeat for Depreciating and Amortization. There is no amortization in our example.

We must annualize this data to construct our cash flow. Recall that the figures are in $1,000s of USD.

The firm’s Depreciation Expense for the 9 months was = 4,618K Annualize Depreciation Expense by dividing it by 9 months and multiplying the result by 12 months.

4,618K / 9 months = 513,1K. The firm reported 513,1K in depreciation expense per month during the first 9 months of 2006.

513,1K x 12 months = 6157,3K. The firm is projected to report 6157,3K in depreciation expense for the 12 months ended December 31, 2006.



It is not necessary to annualize CPLTD. This figure already represents what is to be repaid within the next 12 months. You now have enough information to construct a cash flow based on information from the 9 month interim period.


2003 2004 2005 2006 AnnualizedNet Income 876 313 36 -1043Depreciation 2205 2818 3996 6157

BCF 3081 3131 4032 5115




Alternative Cash Flow: Basic Cash Flow ProjectionWhat if this customer wanted to finance (5) 2009 A25E with dumper bodies for 182,000 each. 8.15% interest rate. 60 months., No down payment. The monthly payment (principal and interest) on 1 unit would be about 3703. The annual payment on 5 units would total 222202.

The units will be additions to their fleet. If they continued to perform the way they have performed in 2006, for the next 5 years, do you think they could service the debt (principal and interest) they have proposed?Using Prior Period (pp) CPLTD

2003 2004 2005 2006 AnnualizedNet Income 876 313 36 -1043Depreciation 2205 2818 3996 6157

BCF 3081 3131 4032 5115




Alternative Cash Flow: EBITDA Cash FlowRecall that EBITDA is a good measure of how efficient a firm is at keeping its operating expenses low. In other words, it is a good measure of Operating Profitability.

Although it is used interchangeably with Operating Profit, these measurements are not the same. EBITDA is superior to Operating Profits because it includes sources of non-Operating income where Operating Profit does not.

It also disregards the effects of Interest which is related to a firm’s Investing activities rather than its operating activities. It disregards taxes which could be manipulated based on the amount of pre-tax income they report. Pre-tax income can be manipulated based on inflated expenses they may report.

It also neutralizes the effect of Depreciation and Amortization because these are non-Cash expenses that do not reflect an outflow of cash from the business.

These additional considerations make EBITDA Cash Flow better than the Basic Cash Flow analysis. It is slightly more complex than BCF but provides an even clearer picture of a firm’s ability to generate cash and amortize debt.

Alternative Cash Flow: EBITDA Cash Flow

Like the BCF analysis, you can use either CPLTD (pp) or CPLTD (cp) for the same reasons as discussed on slide 91. Unlike BCF analysis, Interest Expense is added to CPLTD in the denominator because it is included in the numerator.

Note that the Quick and Dirty Financial Analysis tool uses a slightly modified version of this formula. It uses EBITDA less Cash Taxes and Distributions (Dividends). EBITDA less Cash Taxes is EBIDA. EBIDA works like EBITDA except it says that

Cash taxes are a valid expense item that should be excluded when evaluating a firm’s operating efficiency (i.e. performance).

Distributions are excluded because it is a management decision to distribute earnings to owners in lieu of paying creditors. It would; however, be considered irrational to distribute earnings to owners if creditors have not been paid.

EBIT + Depreciation + AmortizationEBITDA Cash Flow Ratio =

Current Portion of Long Term Debt CPLTD (pp) + Interest Expense

EBITDA

EBIT + Depreciation + AmortizationEBITDA Cash Flow Ratio =

Current Portion of Long Term Debt CPLTD (pp) + Interest Expense

EBITDA

EBITDA Cash Flow Ratio = Current Portion of Long Term Debt CPLTD

(pp) + Interest Expense

EBITDA


Debt Service Coverage 2004 2005 2006 2007 F(In 000's) 12 m 12 m 12 m 12mEBITDA 18 528 40 273 71 975 80 000Dividends 0 0 0 5 000Cash Flow Before Debt Service 18 528 40 273 71 975 75 000

Current Maturities on Long Term Debts 9 971 23 296 42 150 47 000Interes t Expense 15 217 7 733 14 984 16 500Total Debt Service 25 188 31 029 57 134 63 500

Cash Flow After Debt Service -6 660 9 244 14 841 11 500Coverage Ratio 0,74 1,30 1,26 1,18

In this example, we see the result of both the EBITDA ratio (“Coverage Ratio” in the above example) and the Surplus EBITDA Cash flow calculation (“Cash Flow After Debt Service” above)

Alternative Cash Flow: EBITDA Cash FlowSample Trucking CompanyStatement Date 12/31/03 12/31/04 12/31/05 12/31/06Months Covered 12 12 12 12





Using CPLTD (pp)1. What is the EBITDA cash

flow coverage for 2003 – 2006?

2. What is the surplus (or deficit) EBITDA cash flow in those periods?



Alternative Cash Flow: EBITDA Cash FlowSample Trucking CompanyStatement Date 12/31/03 12/31/04 12/31/05 12/31/06Months Covered 12 12 12 12





Using CPLTD (cp)1. What is the EBITDA cash

flow coverage for 2003 – 2006?

2. What is the surplus (or deficit) EBITDA cash flow in those periods?



Alternative Cash Flow: EBITDA Cash FlowUsing CPLTD (pp) Using CPLTD (cp)


2003 2004 2005 2006EBITDA 4213 4055 5084 4616

CPLTD (pp) n/a 3123 3602 3253Interest 663 759 1062 1113

Debt Service n/a 3882 4664 4366

EBITDA Coverage n/a 1,04 1,09 1,06

Surplus (Deficit) EBITDA n/a 173 420 250

EBITDA CoverageTrend n/a n/a Positive Positive

Using Prior Period (cp) CPLTD

2003 2004 2005 2006EBITDA 4213 4055 5084 4616

CPLTD (pp) 3123 3602 3253 4049Interest 663 759 1062 1113

Debt Service 3786 4361 4315 5162

EBITDA Coverage 1,11 0,93 1,18 0,89

Surplus (Deficit) EBITDA 427 -306 769 -546

EBITDA CoverageTrend n/a Negative Positive Negative

Note the differences in EBITDA Coverage and the trend depending on whether or not you use either CPLTD (pp) or CPLTD (cp). While using CPLTD (pp) is more accurate and yields largely positive results, the surplus is actually not that large and disguises the fact that they have larger debt service coming due next year.

Using CPLTD (cp) is less accurate but it is more conservative and forward-looking. As a result, the coverage trend has mixed results which are largely negative. This firm has higher levels of debt service coming due in 2007 possibly because of increased borrowing of term debt. Using CPLTD (cp) shows us that this firm might have problems servicing debt if it does not become more efficient (i.e. generate more EBITDA relative to sales) in 2007.

Sample Trucking CompanyStatement Date 12/31/03 12/31/04 12/31/05 12/31/06Months Covered 12 12 12 12




Notice that our financial statement covers 12 months of data in each period. This makes our calculations simple.

What if the numbers in the last column only represented 7 months of data instead of 12?

How would we adjust our EBITDA Cash Flow formula? Would your opinion of the financials change?



We would need to adjust (or ANNUALIZE) our formula so that we are comparing 12-months of EBITDA Cash Flow to CPLTD that has to be repaid in 12 months. Because the denominator includes interest, this should also be annualized.

In our example on the previous slide, the accounts in the last column only represent 7 months of data instead of 12. We must annualize this data to construct our cash flow. Recall that the figures are in $1,000s of USD.

The firm’s EBITDA for the first 7 months of 2006 was = 4616 Annualize the EBITDA by dividing it by 7 months and multiplying the result by 12 months.

4616 / 7 months = 659. The firm generated EBITDA, on average, of 659K per month for the first 7 months of 2006.

659 x 12 months = 7913. They are projected to generate EBITDA of 7913K during the 12 months ended December 31, 2006.


Repeat for Interest Expense.

We must annualize this data to construct our cash flow. Recall that the figures are in $1,000s of USD.

The firm’s Interest Expense for the 7 months was = 1113 Annualize Interest Expense by dividing it by 7 months and multiplying the result by 12 months.

1113 / 7 months = 159. On average, the firm reported 159K in interest expense per month during the first 7 months of 2006.

159 x 12 months = 1908. They are projected to report 1908K in interest expense for the 12 months ended December 31, 2006. If you know that interest costs will be different from this because they will pay off debt before then or they will have a change in interest costs, use that figure instead.


It is not necessary to annualize CPLTD. This figure already represents what is to be repaid within the next 12 months. You now have enough information to construct a cash flow based on information from the 7 month interim period.

Using Prior Period (cp) CPLTD

2003 2004 2005 2006 AnnualizedEBITDA 4213 4055 5084 7913

CPLTD (pp) 3123 3602 3253 4049Interest 663 759 1062 1908

Debt Service 3786 4361 4315 5957

EBITDA Coverage 1,11 0,93 1,18 1,33

Surplus (Deficit) EBITDA 427 -306 769 1956

EBITDA CoverageTrend n/a Negative Positive Positive


Let’s say they answer than a FH 4x2T combination travels 5,100 km per month and that on a monthly basis, they earn 2.4 per km. That’s 12,420 in revenues generated per vehicle per month.

It is unnecessary to look at the other parts of the Application for Finance Questionnaire. Why? Because the remainder of the application is concerned with overhead costs like drivers, fuel, maintenance, insurance etc. How overhead is managed is another way of saying how efficient management is at keeping operating costs low. If you know what EBITDA is then you already know how efficient management is at keeping overhead costs low.

The question is, how do I convert 12,420 in revenues generated per vehicle per month into EBITDA and how do I determine if this is enough to service the debt?


Recall the formula for EBITDA Margin on slide #69. EBITDA Margin can be used to project EBITDA.


Sales

What was the firm’s EBITDA Margin in 2006? Remember we are comparing the annualized EBITDA to annualized Sales in 2006.

EBITDA Margin = 7,913

75,461= 10.5%

The company retained 10.5% of Sales as EBITDA. This is a measurement of how efficient they were in 2006. If an FH 4x2T generates 12,420 in revenues per month, how much EBITDA will it generate in a year? Will this be enough to service the debt on those trucks?


We projected annualized Sales in 2006 of 75,461,142. Unless something changes, we should expect them to generate at least 75,461,142 in 2007.The proposed trucks can generate 12,240 per month per truck. 1 truck

should generate 146,880 per year. 150 trucks should generate 22,032,000 per year.

Unless something changes, we should expect this company to generate 97,493,142 (75,461,142 + 22,032,000) in revenues in 2007.

With an EBITDA margin of 10.5%, using the additional 150 trucks, this company should generate EBITDA of 10,223,334 in 2007, all things being equal.


We project EBITDA of 10,223,334 in 2007.

Let’s assume that the CPLTD (cp) that we used in 2006 will stay the same in 2007, unless you know different. CPLTD (cp) was 5,957,000. 10,223,334 – 5,957,000 leaves 4,266,337 to service the debt on the new trucks.

The annual payment on 150 units would total 5,106,137. They would not generate enough cash to repay the debt on all the trucks; however, we can surmise that they could generate enough cash to cover the debt on 125 units (annual debt service on 125 units is 4,255,114) leaving no excess or deficit EBITDA cash flow.

The firm would either need to increase revenues, decrease operating expenses (i.e. improve EBITDA), or change the structure of the deal. It is unlikely they can increase revenues or EBITDA to pay for the additional units. In this case, if you lengthened the term from 36 to 48 months, they would have just enough EBITDA to service the debt on 150 units.


Cash Flow

Line Type Amount of Line Utilization Expires

Working Capital MTHB 168.30 MTHB 118.96 2009-06

Cash Flow Statement Comments:

1) EBITDA increased in FY2006 and FY2007. But EBITDA as of Aug 2008 fell by an annualized 19.5% compared to last year. However, the large sales order to PT Thailindo will help to boost up the EBITDA.

2) As at Dec 2008, ITI has been granted various bank facilities which are secured by the company’s bank deposits, the mortgage of the company’s plant and the guarantee of the parent company. Facilities comprises of ; 2.1) Bank Overdraft with 3 banks for MTHB 28.30 (TMB MTHB 15.30 / BBL = MTHB 8.00 / UOB = MTHB 5.00) 2.2) Trust receipts with 1 bank for MTHB 140.00 (TMB)

Note: ITI’s major bank is Thai Military Bank Public Co., Ltd (TMB) and ITI’s payment record is considered good

3) Based on Working Capital Limit of THB 168.30, it has a utilization rate of 71% (MTHB 118.96). The sharp increase in utilization amount was due to an increase in bank overdraft and trust receipts for imported products (non-Volvo brand). The utilization comprises of;

3.1) Bank overdraft with local banks (MTHB 16.94) @ MLR p.a. 3.2) Trust receipt with TMB bank (MTHB 102.02) @ MLR p.a.

Working Capital / Credit Lines

Other References• Bank reference: Thai Military Bank Public Co., Ltd.• Payment Performance: Good

Cash FlowDiscussion Item

What does it mean to be insolvent?

Appendix A

Financial Statements

Types of U.S. Financial StatementsA complete financial statement can take one of several forms. From a creditor’s perspective, some statement types are more desirable than others. The 5 main types of statements, from most preferred to least preferred include the following:

1. Audited• Unqualified• Qualified• Adverse• Disclaimed

2. Reviewed3. Unaudited Compiled4. In house or Direct. Also called company prepared5. Tax Returns

Types of Financial Statements: Audited

• In the U.S., audited financial statements may be prepared by a Certified Public Accountant (CPA) and undergo rigorous independent verification for accuracy to assure strict adherence to generally accepted accounting principals (GAAP). They are the most reliable financial statement a company can present to a creditor to illustrate their true financial condition.

• These statements are the most expensive to prepare.• Please note that there are four variations of an audited financial statement. We will

discuss each on the following slides:1. Unqualified2. Qualified3. Adverse Opinion4. Disclaimed Opinion

Audited Statement: 4 typesWhenever a statement is audited, the auditor expresses an opinion about the information contained in the statement. The terms Unqualified, Qualified, Adverse, and Disclaimed refer directly to the opinion expressed about the statement.

Let’s start with sample language you will find on the transmittal letter of an audited statement:

“We have audited the accompanying balance sheets of Conveyor, Inc as of December 31, 2005 and December 31, 2006, and the related statement of earnings, stockholders equity……..We conducted our audits in accordance with generally accepted accounting principals………In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Conveyor Inc.”

Audited Statement: 4 typesThe auditors opinion letter is usually a letter with 3 paragraphs.

In the first paragraph, the scope of the work performed by the accounting firm is described, it states clearly that the financial statements are the responsibility of management and it is the CPA’s responsibility to express an opinion on the financial statements based on the audit.

In the second paragraph, the auditor elaborates on the scope of the work performed…often indicating that they conducted the audit “in accordance with Generally Accepted Accounting Principals [GAAP]”

The third paragraph is where the auditor gives an opinion about the statements. It may be in a third or fourth paragraph as well depending upon the circumstances.

Audited Statement: UnqualifiedExample Opinion:

“It is our opinion that the financial statements present fairly, in all material respects, the financial position of Conveyor, Inc. as of December 31, 2005 and December 31, 2006”

Their opinion is not qualified….. in that the auditor has not made any comments to lead you to believe that the information contained in the Financial Statement are unfair or worse, inaccurate.

Audited Statement: QualifiedExample Opinion:

“It is our opinion , except for the effects of such inventory adjustments, if any, that might have been determined to be necessary had we been able to verify the amounts in question, the financial statements….present fairly, in all material respects, the financial position of Conveyor, Inc. as of December 31, 2005 and December 31, 2006.”

The auditor’s opinion is qualified….. in that they have not made a qualified endorsement of the statement’s accuracy.

As an analyst, you should take this qualified opinion into account when you review the statements.

Audited Statement: Adverse OpinionLet’s assume that, as a result of the audit, the accounting firm determines that Conveyor, Inc. has a material amount of operating leases (off balance sheet leases, listed only as lease expense on the income statement) that are properly capital leases (the asset and related debt listed on the balance sheet). Consequently, the company should increase its capital assts by the amount of the equipment it has obtained under the capital leases and increase the amount of long-term debt it records in the liabilities section of its balance sheet.

Example Opinion: “In our opinion………..the financial statements referred to above do not present fairly, in all material respects, the financial position of Conveyor, Inc. as of December 31, 2005 and December 31, 2006, as the results of its operations and its cash flows for each of the two fiscal years in the period ended December 31, 2006, in conformity with GAAP”

Audited Statement: Adverse Opinion Continued

In the example opinion, the auditor disagreed with a management decision that (in the auditor’s opinion) materially alters three of the basic financial statements of the company and the information it provides to users, like you. Those statements do not, in the auditor’s opinion, fairly present the financial position of the company.

You should contact the Company and investigate the reason for the auditor’s adverse opinion.

Audited Statement: Disclaimed OpinionLet’s go back to the qualified opinion and assume that the extent of confusion about the ending inventory amounts is so great that the accounting firm feels unable to express any opinion about the financial statements. The opinion paragraph in the transmittal letter might now state the following:

“…we did not have access to the company's records prior to 2006 so that we could not properly verify ending inventory balances for 2005 by means of other auditing procedures, nor could we properly verify the company’s 2006 cost of goods sold.”

Furthermore “…because the company did not maintain adequate records with respect to inventory values, we were unable to verify inventory balances and related expense amounts…..The scope of our work was not sufficient to enable us to express, and we do not express, an opinion on the financial statements referred to herein..”

Audited Statement: Disclaimed Opinion Continued

The statement on the prior slide effectively reduces the value of the information contained in the statement to that of a compiled or reviewed statement because the accounting firm does not offer an opinion about the fairness of the financial statements.

Remember that management has the final responsibility for the content and composition of the data and information in a financial statement. Any negative opinion reflects upon them and should be considered when analyzing statements and making a credit decision.

Financial Statements: Reviewed Statement

If an Unaudited Financial Statement is prepared by an accountant, the financials are prepared to certain professional standards. When prepared to these standards, the statement is referred to as a Reviewed Statement.

A review consists primarily of inquiries of the company’s personnel and analytical procedures applied to financial data. The data is; however, provided by the company’s management and is not tested in detail for accuracy.

These statements are less expensive to prepare than Audited Statements.

Financial Statements: Compiled Statement

Compiled Financial Statements are prepared from information provided by the company without any attempt to independently verify their accuracy.

This type of statement may be prepared by anyone. The data is provided by the company’s management and is put into the form of a Balance Sheet and Income Statement. It may or may not comply with US or International accounting standards. Additionally, there is no testing of the data to assure its accuracy.

Compared to Reviewed statements, these statements are less expensive to prepare.

Financial Statement: In house or Direct Statement

These statements are prepared for management’s internal discussion and may or may not represent the true financial condition of the company.

Compared to accountant prepared statements, these statements are the least expensive to prepare.

Financial Statements: Key PointsKey Points to Remember:

• At a minimum, a complete financial statement consists of:Balance SheetIncome Statement

• There are multiple types of financials statements. From a creditor’s perspective, the most desirable is an Unqualified,

Audited Statement.The least desirable is an internally prepared or tax return statement.Qualified, Adverse and Disclaimed accountant opinions must always

be discussed in your presentation.

Balance Sheet – Long Term Assets

Appendix B

Balance Sheet: Long Term Assets – Accumulated Depreciation

Other than land (although there are exceptions to this), most fixed assets depreciate over time. That is, the asset is used up over time. Examples of Fixed Assets that depreciate include transportation equipment, buildings, software, etc. They are listed on the balance sheet at their original acquisition cost. We sometimes refer to this as the Gross Value.

The account used to measure how much of an asset has been used up or depreciated is called Accumulated Depreciation. The difference between an an asset’s Gross Value and Accumulated Depreciation is its Net Book Value.

Gross Value – Accumulated Depreciation = Net Book Value

Balance Sheet: Long Term Assets – Depreciation Types

There are many ways to measure how these assets become used up or depreciate. The methods used to measure how they depreciate are varied and depend on the type of asset.

Types of Depreciation include:• Straight-Line• Accelerated (Double Declining)• Modified Accelerated Cost Recovery System (MACRS)

This class will focus on the Straight-Line Method

Under the Straight-Line Method, a standard truck may have an useful life of 5 years. So each year, the truck loses 1/5th of its value. In two years, 2/5ths of the value has depreciated.

Balance Sheet: Long Term Assets Straight-Line Depreciation Method

Example: A truck is acquired for $100,000 (USD) at the beginning of the year. It has a 5 year useful life, that is, its value will depreciate to zero at the end of 5 years.

At the end of 1 year, 1/5 of the truck’s acquisition cost is depreciated.

The acquisition cost is still $100,000 but $20,000 (1/5th of $100,000) in depreciation has accumulated leaving a net book value of $80,000 at the end of the first year.

$100,000 - $20,000 = $80,000

$100,000 is the original acquisition cost of the truck; its gross value. $20,000 in depreciation has accumulated during the year; hence the name, Accumulated Depreciation. $80,000 is the net book value of the truck. The net book value does not necessarily represent the truck’s actual market value. At the end of the second year, $40,000 in depreciation will accumulate and the net book value of the truck will decline to $60,000.

Do you see the difference between the truck’s gross value (Gross Fixed Asset) value and its net book value (Net Fixed Asset) value? Do you understand the difference between net book value and market value of this asset?

Balance Sheet: Long Term Assets Straight-Line Depreciation Method

Example: A truck is acquired for $100,000 (USD) cash on January 1, 2008. It has a 5 year life, that is, its value will depreciate to zero at the end of 5 years.

Balance Sheet Jan 1, 2008 Dec. 31, 2008Year 1

Dec. 31, 2009Year 2

Dec. 31, 2010Year 3

Dec. 31, 2011Year 4

Dec. 31, 2012Year 5

Acquisition Cost $100,000Asset

AcquiredCash Outflow

$100,000No Cash Outflow





Less: Accumulated Depreciation

$0 $20,000 $40,000 $60,000 $80,000 $100,000

Net Book Value $100,000 $80,000 $60,000 420,000 $20,000 $0

Income Statement

Depreciation Expense

$0 $20,000No Cash Outflow





Balance Sheet: Long Term AssetsOther Non-Current Assets

• Cash Value of Life Insurance• Certain Notes Receivable

Non-current assets can include a variety of asset accounts that are not expected to be converted into cash within the next 12 months.

• Goodwill• Non Compete Agreements• Intangibles

From a lender’s perspective, some types of assets may not be convertible into Cash; that is, if you were forced to liquidate the company’s Balance Sheet, these assets do not have any value. They are intangible. These include but are not limited to:

Appendix C

Other Ratios

Balance Sheet: Inventory DOH

*One flaw in this formulas is that it compares a whole year (or y-t-d) Cost of Sales with inventory at a specified time; it does not recognize seasonal fluctuations.

Low inventory turnover can indicate possible overstocking, obsolescence, or poor production planning, while a very high turnover ratio can be a warning of the possibility of stock-outs and delayed shipments.

Inventory DOH will tell you how long it will take to turn 1 dollar of inventory into 1 dollar of sales.

Inventory*COGS x 365 = A/R DOH

Balance Sheet: LeverageIn addition to leverage, we should also be concerned with our total exposure relative to the company’s Equity.

Example: A company has requested financing for $3.0MUSD in equipment. If financed, $3.0MUSD will be our total exposure with this company. The company currently has $500KUSD in Equity and $5.0MUSD in Total Liabilities. Additionally, the company has $250KUSD in Goodwill and other intangible assets.

• What is the company’s leverage ratio?

• How much do the owner have invested in the company versus our proposed exposure?

Balance Sheet: Capital StructureCapital structure is a mix of a company's long-term debt, specific short-term debt, common equity and preferred equity. The capital structure is how a firm finances its overall operations and growth by using different sources of funds.

Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital requirements is also considered to be part of the capital structure.

A company's proportion of short and long-term debt is considered when analyzing capital structure. When extracting this information, you should categorize debt as current or long term. It is highly unusual for a company to have long term debt and no current portion of long term debt.

When people refer to capital structure they are most likely referring to a firm's debt-to-equity ratio, which provides insight into how leveraged or risky a company is.

Usually a company more heavily financed by debt poses greater risk, as this firm is relatively highly levered.

Appendix D

Income Statement Additional Information

Income Statementd) Operating Expenses

These are commonly known as selling, general and administrative expenses(SGA) and consume the gross profit. They arise during the ordinary courseof running a business. Operating expense may include the following:

• Insurance• Operating Lease Expense• Salaries paid to the employees• Travel expenses• Legal & Other Professional Fees• Depreciation and Amortization charges

In your presentation, when you analyze Operating Expenses; you should discuss management’s efficiency because management’s goal is to keep operating expense as low as possible in order to maximize profits while not damaging the business.

Income StatementDepreciation & Amortization Expense Recall that no cash flows out of the business when we record Depreciation and Amortization Expense. They are non-Cash Expenses. We need Depreciation and Amortization expense broken out for the Cash Flow analysis. These expenses could be included among the Cost of sales or Operating Expenses. They could be located on the company’s Cash Flow statement or located in the Notes to the Financial Statement. If not found, it is imperative that you ask management what these figures are and extract them in your analysis.

Income Statement AnalysisGross Profit Margin:

• This first indicator shows the ability of a company to earn a profit.• Represents the residual profit from each sales dollar after accounting the

Cost of Goods Sold. • Because it is expressed as a percentage, it can be compared to earlier or

subsequent periods or even be compared to similar firms.

(F) Gross Profit Revenues

(E) 1,720 26,014 = 0.071 x 100 = 7.1%

An analyst should ask management about any large changes in Gross Profit Margin period-over-period. If this figure is positive and unchanged period-over-period, then this is a good indicator that costs are in line with revenues. If it is negative, costs exceed revenues and questions should be asked.

x 100

Income Statement AnalysisOperating Profit Margin

It represents the residual profit per dollar of sales after accounting for allmajor operating costs. When looking at operating margin to determine thequality of a company, it is best to look at the change in operating marginover time. If a company's margin is increasing, it is earning more per dollarof sales. The higher the margin, the better.

(F) Operating Income Revenues

(E) 745 26,014 = 0.08 x 100 = 2.8%

An analyst should ask management about any large changes in Operating Profit Margin period-over-period. If this figure is positive and unchanged period-over-period, then this is a good indicator that costs are in line with revenues. If it is negative, costs exceed revenues and questions should be asked.

Income Statement AnalysisNet Profit Margin

It represents the residual profit per dollar of sales after accounting for allmajor operating and non-operating costs. If a company's Net Profit Margin is increasing, it is earning more per dollarof sales. The higher the margin, the better.(F) Net Income Revenues

(E) 372 26,014

= 0.01 x 100 = 1.3%

An analyst should ask management about any large changes in Net Profit Margin period-over-period. If this figure is positive and unchanged period-over-period, then this is a good indicator that costs are in line with revenues. If it is negative, costs exceed revenues and questions should be asked.

Income Statement AnalysisInterest Coverage Ratio:

(F) E B I T Interest Expense

(E) 3355 145

= 23.1

This ratio computes the number of times ordinary income before interest and taxes covers interest payments. Companies with poor interest coverage should be viewed cautiously. As an analyst, you should address poor interest coverage.The ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) of one period by the company's interest expenses of the same period. An interest coverage ratio below 1 indicates the company is not generating sufficient profits to satisfy interest expenses.

Thank you!

Dejan JeremićDejan Jeremić

[email protected]

Credit Training[Finall]

Economy & Finance

Transcript of Credit Training[Finall]