Resources for Lenders, Community Bankers & Finance Professionals

As you can see, there can be a high degree of variation in COS and inventory when different inventory methods are used. 

Key Ratios:

Inventory Turnover Ratio = Inventory/COS*365

 

Questions:

 

1. What are your primary products?

2. What materials go into your manufacturing process?

3. Do you have any stale inventory on your balance sheet?

4. How many sources of raw materials do you have?

5. When was the last time you took physical inventory?

6. How often do you take physical inventory?

7. How do determine when it is time to reorder?

8. In what quantities do you typically order inventory? 

 

Advanced Analysis:

For retailers:  For retail customers, it is important to understand the market in which the retailer participates. Computer retailers have to make sure that the inventory is not too stale. Technology based companies are subject to rapid obsolescence, and yesterday’s technology becomes almost worthless.  Clothing retailers inventory can become out-of-style quickly and changes from season to season. Food related companies have to worry about expiration dates and spoilage.  

 

For manufacturers:  It is important to understand the age of raw materials and finished goods. Frequently, inventory can hide stale inventory that has little or no value.  Understanding the manufacturing process is important when reviewing WIP.  Excessive WIP may indicate production issues or the understatement of cost of sales.

It is always important to understand the valuation method for inventory. Keep in mind that businesses that take trade-ins may have hidden value in their inventory.  Additionally, companies that carry parts, such as an automobile dealership may have undervalued inventory if there has been an increase in parts prices  from the manufacturer.  On the other hand, parts inventory may lose their value when product lines are discontinued.  

Advanced Questions:

 

1. How much inventory do you keep on hand?

2. Do you have a LIFO reserve?

3. Do you have any raw materials that lose their effectiveness over time?

4. Do you have any inventory leftover from a discontinued product line? What is its value?

5. What main types of inventory do you have?

6. How quickly does each type turn?

 

Prepaid Expenses

 

Prepaid Expenses are payments made in advance of the performance of the activity for which the payment is being made.  As the activity occurs, the amount of prepaid expenses is reduced.  The most common example of prepaid expense is insurance. A premium is paid for the insurance. As time proceeds, prepaid insurance is reduced.  Prepaid expenses typically don’t require an extensive amount of analysis. Some less-sophisticated companies may not be properly recognizing their prepaid expenses, skewing expenses in a period in which the payment is made.

 

Fixed Assets

 

Fixed Assets (a/k/a Property, Plant and Equipment, PP&E) are long term assets which useful life spans more than one period.  Fixed assets can include land, improvements, equipment, and buildings. According to Generally Accepted Accounting Principles (GAAP), fixed assets are valued at their acquisition cost plus the direct costs necessary to put the equipment into production.  GAAP recognizes that fixed assets may lose their value over time, which is called depreciation. Over the years, GAAP and the IRS have developed certain lives and accounting procedures for different classes of assets. A building is depreciated over a longer period than a truck.  The net value of a fixed asset, reflects the purchase price and installation costs of the asset less depreciation that has occurred since the asset was put into use, called accumulated depreciation. The analyst should note that market value and book value are different concepts. The net present value of an asset will diverge from the market value of the asset, sometimes at the time the asset is put into use but almost always over time.  While the book value of fixed assets is important for accounting purposes, it is irrelevant for loan repayment. The market value of assets is far more important. It is the analyst’s and loan officer’s role to help determine the market value of these resources and their usefulness to the client. 

 

Example:  A 20,000 warehouse was purchased ten years ago for one million ($1,000,000) dollars.  During the ten years since the purchase, the market value appreciated by 30% while the financial statements reflect a 30% loss in value.         

Questions:

 

1. Do you own your facility?

2. Is your equipment leased or purchased?

3. Do you have a depreciation schedule/fixed asset schedule?

4. When was your equipment put into service?

5. Do you have any formal equipment appraisals?

6. Over what period do you write-off the equipment?

7. Do you subscribe to any equipment guides/publications?

 

Advanced Analysis:  

The book value (which is the depreciated value according to GAAP) consists of the gross value of the fixed asset less accumulated depreciation realized to date. The net book value is used to determine the gain or loss on the sale of the asset at the time of disposition. Comparison of the loss or gain to the net book value provides us with the basis to determine proceeds from the asset sale for cash flow purposes. 

Fixed assets should be reviewed for hidden depreciation or appreciation. The easiest way to obtain this information is to compare the fixed asset to a similar asset with like attributes. Usually, trade publications, valuation guides or appraisals are the best sources. Most of this type of information is already online.

 

Liabilities

 

Accounts and Trade Notes Payable

 

Accounts and trade notes payable represent amounts due trade creditors, suppliers and service providers. They typically occur in the ordinary course of business of the borrower.

 

Analysis:

 

It is important to review account payable from two different perspectives. The first is to evaluate the borrower’s ability to access trade credit. Trade credit is an important part in managing cash flow.  Usually established companies seek to manage the number of days in which they pay their trade creditors, not paying early unless a discounted is provided.  On the opposite extreme,  the lender should also be cognizant of problems with trade creditors. This is usually indicative of companies with stretched trade payable that exceed the terms provided. Companies in this situation may be in the process of being cut-off by its suppliers. 

 

Ratios:

Accounts Payable Turnover
Accounts Payable Turnover – days  (Accounts payable/trade purchases*365)
If purchases are not available, the use:
Accounts Payable Turnover – days (Accounts payable/Cost of Sales*365)

 

Additional Documentation to be requested/obtained: 
Accounts Payable Aging Schedule
Credit Bureau – D&B, seafax, etc.

 

Advanced Analysis:

The analyst should review the D&B report for delinquencies and collection actions.  Most companies have an occasional blemish; however excessive delinquencies or negative trends reveal negative cash flow or poor management.  The analyst should also review the accounts payable aging schedule, looking for payables with excessive delinquencies.   Accounts payable turnover may reveal some slowness, which supports cash flow. A comparison to previous periods is helpful in determining trends. Comparison to RMA industry data is also helpful.  For the analyst, some delinquency maybe good; but too much is deadly.

 

Notes Payable

 

Notes payable consists of short term bank debt with maturity of less than a year. This includes lines of credit, revolving credit facilities and time notes. The analyst should review the note schedule and any covenants that may be in violation, the purpose for the debt and if the debt was used for its intended purpose. Availability under a line of credit may be an important component when reviewing liquidity. A company with undrawn lines of credit is better equipped for downturns, opportunities and unexpected events.  

 

Accrued Liabilities

 

Accrued liabilities include those expenses that have been incurred but not yet paid.  It can be difficult to determine the accuracy of accrued liabilities on the balance sheet. First, ask about the accrued expenses listed on the balance sheet – What are they? What do they consist of?  How are they recognized? A few questions regarding the timing of expense recognition can provide insight.  Accrued expenses should be compared period to period to determine if they are being adjusted. Note: Accrued expenses do not appear on statements prepared on a cash basis.  

 

Long-Term Debt

 

Long-term debt consists of term debt or debt that is scheduled to be repaid in more than one fiscal year. Long-term debt is divided into two components, current maturities and long-term. The current maturities piece, is classified on the balance sheet under the current liabilities and represents that principal amount due within the next year. The long-term is that portion that extends beyond a year.

 

Additional Documentation:  Schedule of debts (may be prepared by analyst) divided by note, and including interest rate, maturity and collateral.

 

Ratios:
Debt Service Coverage Ratio -

 

Advanced Analysis:

 

It is extremely important to determine the borrower’s ability to generate adequate cash flow from operations to support its debt service and proposed debt service.  The analyst should also determine if there are any defaults (payment issues, covenant violations) of existing debt.  Does the company’s debt structure make sense or is it structured improperly based upon cash flow and collateral situations. Many financial institutions seek to keep the maturity of debt very short, which may be a mistake if cash flow and collateral dictate a longer maturity.  For example, a piece of equipment is purchased which has a life of 10 years and the company’s cash flow easily supports a five year amortization. If the lender puts the loan on a four year amortization, which would possible though difficult for the borrower to meet, it has done him a great disservice as it has restricted his ability to support any growth and if some unforeseen event occurs can force him into a payment default. 

 

Capital Leases

 

Capital leases are leases that are treated as loans, according to GAAP. They in some manner transfer a substantial portion of the economic life of an asset to a lessee. Accordingly, the asset being funded is listed on the balance sheet and the liability is listed as a capital lease.  Capital lease payments include an interest component and a capital lease component, just like a term loan. On the other hand, payments on an operating lease only show up on the income statement as a lease expense.  See Leasing

Capital leases have one advantage in a bankruptcy court over traditional debt, as the lessor has the option whether it wants to continue the lease or pick-up its equipment (with the bankruptcy courts approval).   

 

Subordinated Debt

 

Subordinated Debt is debt which is treated as equity. It is frequently provided by affiliates or shareholders. It is expected to be repaid, but only after some other debt is. There is usually a subordination or standby agreement, which contractually limits the interest rate and rate at which the debt can be repaid. It also dictates a subordinate position in a liquidation situation, whereby the senior lender is paid first.  

 

Equity

 

The equity section typically includes Paid-In-Capital and Retained Earnings. There may be a few different terms and sub-classifications of these items on the balance sheet, such as par and paid-in-capital in excess of par. The balance sheet might also divide current net income from retained earnings. In essence, either capital was invested in the company or was retained by the company. Subordinated debt may be moved into the equity section by the analyst when it is put on standby or subordinated. Your institution needs to make the conclusion as to whether any interest or principal may be paid under your subordination documents. Dividend and disbursements should be calculated to see if any covenant violations have occurred, if applicable.

 

Key Ratios:

 

Dividend Pay-out Ratio

Debt/Tangible Net Worth