In the past, the banker never bothered about the analysis of the financial statements while lending. He was more concerned with security and margin requirements. But now in the extension of any accommodation, the banker investigates all aspects of the borrower’s business and also his personal character, capacity, and capital. Let’s know first what is balance sheet.
The banker wishes to ascertain whether the lending may be considered safe and whether repayment within a reasonable time can be fairly foreseen. In this task of financial appraisal of the credit proposal and the evolution of the borrower’s creditworthiness, the financial statements of the business are of great value to the banker.
The two important financial statements in these respects are the Balance Sheet and the Profit and Loss Account of the business. In the case of trading concerns, the Trading and Profit and Loss account are prepared but in the case of manufacturing concerns, the manufacturing account, trading account, and profit and loss account are prepared.
Since these statements provide and summary of the financial position of a concern, they are collectively called “Financial Statements.”
What is Balance Sheet?
A balance sheet is a financial statement expressing what a business organization owns and what it owes on a particular date. The profit and loss account shows the financial result of the working of an enterprise over a period of time.
When these statements of the last few years are studied and analyzed, significant conclusions may be arrived at regarding the changes in the financial position, the important policies followed, the trend in profits, etc.
Analysis and interpretation of the balance sheet have now become an important technique of credit appraisal. By analysis of a balance sheet we mean the process of breaking down a complex set of facts and figures into simple elements, i.e., the figures given in the financial statement will not help one unless they are put in a simplified form.
Interpretation of a balance sheet means critically examining these elements to draw conclusions therefrom regarding the progress, financial position, and prospects of a company. However, both analysis and interpretation are complementary to each other. Interpretation requires analysis, while analysis is useless without interpretation.
These financial statements are analyzed and interpreted by different classes of persons from different angles to serve their respective purposes. Though the basic technique of appraisal remains the same in all cases, the approach and emphasis in analysis vary.
A banker’s approach to the analysis of these statements, known as credit analysis, is essentially different from that of the investors and the management.
As a lender and creditor of his borrower customer, he is interested in session the solvency or the repaying capacity of the borrower as is evident forms his financial statements. He is concerned with the estimation of the risks, if any, involved in lending to the borrower.
By analyzing and interpreting the balance sheet the banker wants to find out the following:
1. The organization is financially sound and stable, i.e., whether it is solvent. A reliable picture of the change in the financial position of the borrower can be had by observing whether his net worth, viz., own money (capital, free reserve, surplus, etc.) is on the increase which should be the case with any progressive concern.
2. If the sales of trading concern or the production of a manufacturing unit show an increase from year to year, it will indicate that the concern is growing. A fall or stagnation in sales is an unhealthy sign unless satisfactorily explained.
3. If the sales of trading concern or the production of a manufacturing unit show an increase from year to year, it will indicate that the concern is growing. A fall or stagnation in sales is an unhealthy sign unless satisfactorily explained.
4. Its liquidity is satisfactory. A scrutiny of the balance sheet brings out the extent of the liquidity of the borrower’s business or its ability to meet its liabilities as and when they arise. Unless the position is liquid, the business cannot command the usual credit in the market. Ordinarily, the balance sheet should indicate that current liabilities can be met without recourse to the fixed assets of the business.
4. A study of the balance sheet shows the policy of extending credit to customers as compared to the usual practice prevailing in healthy concerns carrying on the same trade. Similarly, the promptness with which the creditors are being paid can be known from the balance sheets over a number of years.
5. It reveals the extent to which profits are being retained in the business.
6. It indicates the total long-term loans and debenture liabilities and the assets charged as security for such borrowings.
7. It reveals the extent to which over-term borrowings for long-term capital requirements, thus disturbing the financial equilibrium of the concern.
8. In general, a study of the balance sheet should prima facie reveal whether or not the concern is healthy and growing and has a promising future.
General
Balance Sheets are as varied as the human activities they represent. As stated earlier, there is, therefore, no rule of thumb or golden formula for the interpretation of balance sheets.
It should also be remembered that lending is an art and not a science; there is no plane in the art of lending for rules of thumb; financial analysis will not give an absolute answer to every question of doubt but it can, and will, and will, point to the direction in which further inquiries should be made.
It may probably be found useful if the following hints are taken into consideration while analyzing and doing an interpretation of balance sheets.
1. The latest balance sheet of the borrowing concern should be looked into and every large item examined. A comparative study should also be made with the figures of the previous balance sheets for a few years, preferably three or more.
2. The auditor’s report forms an essential part of the balance sheet and should normally be unqualified. If otherwise, the matter requires further investigation.
3. The directors’ report and the chairman’s speech should be studied along with the balance sheet for a better understanding of the various points covered therein.
4. Market surveys and general trends in the industry should be studied. These will serve as a background for proper understanding of the company concerned.
5. Wherever there is a doubt regarding the classification of a particular item, whether it is a current asset or a fixed asset or, is a current or a long-term liability, necessary enquires should be made from the borrower in this regard.
6. The various ratios should be worked out as indicated earlier and inferences are drawn. Explanations should be asked where necessary.
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