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Evaluating Financial Statements

Contents Financial Statements 

Analyzing the Income Statement


The income statement must be analyzed in conjunction with the balance sheet and statement of cash flows to provide a complete picture of a company.  The income statement measures how a business is doing at generating a profit, as profits provide the basic motive for starting a business or continuing in business.  As the income statement is divided into sections, its analysis should also encompass these main components: revenues, gross profit/cost of sales, operating expenses, interest expense,  non-cash charges (depreciation and amortization), extraordinary items, and net income/ losses. 

The key components in reviewing the income statement:




Are revenues increasing, decreasing or stable? Increasing revenues may or may not be a sign of healthy operations.  The two major components of sales are price and volume.  The relationship between the two must be recognized and must be able to be articulated by management.  An increase in sales volume that is triggered by a reduction in pricing may be positive or negative depending on its impact on the gross margin and the amount of operating leverage in the business. 


Price x Volume = Revenue
(1 + % Change in Price) x (1 + % Change in Volume) x prior period revenue = Change in Revenue


Determine if the increase or decrease in revenue is a result of pricing or volume.



  1. Are your statements prepared on a cash or accrual basis?

  2. What major factors have impacted your revenue during the past XXX years?

  3. Have you added or lost any major clients in the past year?

  4. Who are your major clients and what percentage of sales can be attributed to them?

  5. How are they priced?  Any changes in pricing?

  6. What volume does each customer do?

  7. When is a sale recognized?

  8. Have there been any changes in accounting for sales?

  9. When was your business formed?

  10. Was it a continuation of a previous business?

  11. Who is your main competition? When were they established?

  12. Is this an old line industry or a high tech one?

  13. How quickly is the industry growing?

  14. How has the economy impacted your business?

  15. Who are the new players in the industry?

  16. Any industry consolidations?

  17. How is your product delivered to your customers?


The degree of revenue growth is frequently tied to the business’ position in its life cycle and the status of the industry.

A young company may have higher percentage comparative growth relative to a more stable competitor.  It is usually much easier to grow from $100 in sales to $200 than from $100,000 to $200,000. Accordingly, revenue growth should be stated on a dollar basis as well as a percentage basis.  


Every industry is changing, even the most mature ones. The stage of the industry can provide insight into a business and potential influencers on earnings and cash flow. Many newer industries are subject to frequent change, technical obsolescence, rapid growth, and weak or negative cash flow. These types of industries are not typically financed by commercial lenders, rather their needs are seed or venture capital driven.  Lenders prefer stable industries as cash flow from operations tend to be steady or increasing, all other factors held constant. Declining industries may produce healthy cash flow in the early stages of the sales decline, but attention should be paid to declines in sales volume.


Usually higher sales growth translates into lower cash flow from operations as it requires cash to build inventory and accounts receivable.  Sales declines should also be evaluated to determine if they are temporary or permanent.  Sales should be evaluated in conjunction with accounts receivable turnover, dilution (adjustments to the invoice amounts) and bad debt expense.


Key Ratios: 
Sales Growth Rate
Accounts Receivable Turnover
Dilution Percentage (Invoice adjustments (chg)/Total Gross Invoices)
Bad debt expense (dollar and as a percentage of sales)

Advanced Questions:

Some possible questions for an analyst to ask are:


  1. Any long term contracts? Major contract contingencies?  Terms?

  2. What discounts or allowances do your customers take?

  3. What is your revenue by division?

  4. How is your pricing relative to your competition?

  5. What do you expect to happen over the next couple years? 

  6. What efficiencies can be derived from higher sales?

  7. How do evaluate customer profitability?

  8. What is your return policy? How have returns been?

  9. Do you have any consignment sales?

  10. Are there any government controls on sales?

  11. Does your industry require any special licenses?

  12. Geographically, where do you sell?

  13. Is there any special equipment required for your industry?

  14. Is this equipment readily available?

  15. Are there any new competitors?

  16. Do you provide any discounts for early pay?

  17. Do you provide any discounts for bulk sales?

  18. Is your product intended for the end-user or is it a component for  another product?

  19. Is a substitute for your product readily available?


Additional analysis may be required, check industry trade publications for the following industry topics: 1) Industry growth, 2) Government regulation, 3) Major new innovations, 4) Other influencers (such as weather for the agricultural industry), and 5)Foreign competition. 


Gross Margin


The trend in gross margin can tell us a great deal, but it can also be misleading. When the gross profit as a percentage of sales increases, it is considered favorable. When the gross profit as a percentage of sales declines, it requires further investigation. The most common cause for a decrease in the gross margin is an increase in cost of sales which cannot be passed along through a price increase.  This may be due to competitive reasons, which may prevent the firm from raising prices at the risk of losing sales.  A reduction in gross profit as a percentage of sales coupled with an increase in sales may be a result of the introduction of a new product line or acquisition of a new client that requires tighter pricing. Efficient utilization of equipment may also have an impact on the gross profit. Here are a few questions that the officer or credit analyst can ask to explore the topic further:




  1. Have you changed your pricing in the past year?

  2. Have you added any major customers in the past year?

  3. How do you compete in your market; pricing, service, on-time delivery, etc.?

  4. Have you changed your manufacturing process in the past year?

  5. Any new locations, branches, etc.?

  6. Have any of your major suppliers changed their pricing in the past year?

  7. What is the capacity of your facility? How close are you to reaching that capacity?

  8. When did you last have a price increase?


Key Ratios
Gross Profit as a percentage (%) of sales


Advanced Questions:


  1. Are there any pricing advantages in your industry for early pay? Do you take advantage of them?

  2. What price breaks do you have for volume purchases?  Do you take advantage of these?

  3. Have you determined a per unit standard cost?

  4. What efficiencies do you derive from producing in a higher volume?

  5. How do you value inventory?  If on a LIFO basis, what is your LIFO Reserve?

  6. Ask for a copy of inventory and cost of sales closing adjustments if there are any concerns about COS or inventory


Through these questions the analyst is not only looking for insight into future impacts on costs of sales, he is also trying to evaluate management’s knowledge of the industry and understanding of the variables that impact their business.  While less-educated management may not have the business vernacular, they should be able to describe these topics in their own words.   


Depreciation, Amortization and Non-Cash Charges


Non-cash charges are expenses that do not impact cash. They are used to account for the wasting or deterioration of fixed assets and the expensing of intangible assets. This is important because these expenses are added back when determining cash flow. Is the company depreciating assets or amortizing start-up costs/goodwill?   Tax accounting or some GAAP accounting conventions may skew profitability.  The depreciation expense should be compared to the actual depreciation of the asset. For instance, a shipping container might have a five year depreciation schedule, but still be useful for 20 years. If known, then the actual depreciation of the asset may be used when making a determination of core profits.  Be careful about adding back true depreciation, as the asset may actually be losing value at the rate stated.


Key Questions:


  1. What assets do you need to operate your business?

  2. Do you have all of the equipment that you need?

  3. What additional equipment do you plan on acquiring?

  4. How long does this equipment work?  Over what period do you write these major assets off – on you financial statements? Tax returns?

  5. Do you plan on writing off any equipment this year?

  6. Do you have any equipment on you books that you no longer use? What do you plan on doing with it?

  7. Have you sold any equipment lately?  What are the particulars of the equipment? What did it fetch?

  8. Do you have any industry equipment guides/auction guides?


Advanced Analysis:                                              
The purpose of this section is to determine the amount of non-cash charges such as depreciation and amortization and provide a rough comparison with the actual decline in the value of the asset. Large discrepancies should be noted. Depreciation is an accounting convention whereby a business is allowed to write-off the value of a capitalized asset over its useful life.  Useful life has changed for the years and now means some period determined by the type of asset as prescribed by the Financial Standards Accounting Board or the Internal Revenue Service.  Additional research can be done for equipment intensive companies, where depreciation is a major expense.  In these cases vendors can be contacted to provide a rough evaluation. In the case when liquidation of collateral is a major source of repayment, outside appraisal or auction firms can be contacted for a more formal evaluation.  Attention should be paid to the economic cycle for equipment intensive industries, as equipment may devalue rapidly in weak economies.  Amortization is an accounting convention whereby a company writes-off intangible assets, such as goodwill. Amortization has no impact on cash flow and may be added back for analysis purposes.   Be cognizant that the companies that sell into the industry commonly use inflated valuations when providing a collateral value.  One should ask, how much will you buy this from me if I have to take it back?


See Understanding Collateral for Lenders for further discussion of the different methods of valuing equipment.


Operating Expenses


Operating expenses should be reviewed as a dollar amount and as a percentage of sales.   Operating expenses can be broken down into three categories: fixed, variable, and step-variable.  Fixed costs remain fixed, like a salary, even if there is an increase or decrease in sales.  As a percentage of sales, fixed costs decline when there is a sales increase and increase when there is a sales decrease.  This is called operating leverage.  Variable costs increase proportionately with changes in sales, such as commissions. Step-variable costs remain fixed until some sales or capacity threshold is reached. This may be the cost of adding another cook in a restaurant or additional phone lines. The following provides an example of three types of costs:



Financial Statements

Ratio Analysis

Gross Margin
Depreciation & Amortization
Operating Expenses

In this simplistic example, fixed costs remained the same dollar amount but changed as a percentage of sales. Variable costs remained the same percentage of sales, but changed in dollar amount. The step-variable amount changed as both a percentage of sales and as a dollar amount.  


Here are a few questions that the officer or credit analyst can ask to explore the topic further:


  1. Have you added any employees?

  2. How do you compete in your market; pricing, service, on-time delivery, etc.?

  3. Have you changed your manufacturing process in the past year?

  4. Any new locations, branches, etc.?

  5. Have any of your major suppliers changed their pricing in the past year?

  6. What is the capacity of your facility? How close are you to reaching that capacity?

  7. When did you last have a price increase?


Advanced Analysis: 
The purpose of this section is to determine if the company has a high degree of operating leverage which remains fixed when there are major increases or decreases in sales.  Companies with high degrees of operating leverage will see large increases in income when there is sales growth.  For the credit analyst, companies with a high degree of operating leverage that are operating at or near breakeven, are riskier than those with a higher variable cost structure.  Once a company has consistently exceeded break even sales, then the one with higher operating leverage will be more profitable and more bankable.  Therefore, expectations of future sales can play a very important consideration when evaluating operating expenses. 

Advanced Questions:


  1. How much more capacity can be derived from your equipment?

  2. Could you add an additional shift is you had a sales increase?

  3. Do you have any expansion plans?



Other Revenue & Expenses/Gains & Losses


Gains and losses result from peripheral activities or non-core aspects of the business. If they are immaterial they can be combined and reported as a total on the financial statements. As an analyst, it is important to explore these items if they are significant. Write-downs may be indicative of greater issues. Other revenue and expenses are not related to the central operations of the company, such as interest revenue and expenses (we separate interest expense for analytical purposes).


Interest Expense


Interest Expense is amount paid to a lender for the use of their funds. Interest expenses should be evaluated in conjunction with the debt section of the balance sheet. A schedule of debt can be very helpful when evaluating interest expense.  In addition to interest expense, operating lease expenses, capital leases and factoring expenses should be reviewed.


Sample Debt Schedule:

Interest expenses

Key Questions:


  1. What are your various debts? Interest rates on them? Fixed or floating?

  2. Who provided the debt?

  3. Have you refinanced any debt in the past year?

  4. Have you made any major equipment purchases in the past year? How did you finance them?

  5. Do you lease any equipment?  What is the term? Are there any purchase options at the end of the lease term?

  6. Will you have debt repricing in the next year or two?


Advanced Analysis:
When evaluating interest expense, particular attention should be paid to coverage ratios.  Debt service requirements should not exceed cash flow from operations or it places the solvency of the company in jeopardy.  In regards to interest expense, any recent or future debt repricing should be included in your analysis when evaluating the ability of the company to repay its debt obligations.   Additional equipment purchased should provide enough profitability to justify the purchase.


Interest Coverage ratio 
Debt Service Coverage Ratio


Extraordinary Expenses (Non-recurring and Unusual)

Extraordinary expenses are expenses that are unusual and infrequent in nature. Extraordinary expenses may be added back to income in evaluating cash flow from operations. These expenses typically occur when a company discontinues a major business line, closes down a division or experiences something that is so extraordinary that it cannot be expected to recur. From a practical standpoint, extraordinary expenses do not typically occur on the statements of smaller companies.  When evaluating extraordinary items on the income statement of a firm, it is important to evaluate the impact that the discontinued operation had on overall performance and what impact the loss will have going forward.



  1. What caused the extraordinary item?

  2. Why?

  3. How was it related to your other businesses?

  4. What impact do expect this to have going forward?

  5. How much did this division contribute to revenue? Profit?


Income Taxes



  1. Is the company is an S corporation?

  2. Does the company make distributions for tax purposes?

  3. Do the shareholders have offsetting losses to cover the tax exposure?


Net Income

Net income is the culmination of the interaction of previous components. It measures the return available to shareholders.  The analysis of net income should hit the high points of the previous sections and provide the capstone analysis which pulls them all together.


For example:  Revenue growth of 6% and 8% in fiscal years 2009 and 2010, coupled with volume pricing discounts and relatively fixed operating expenses which did not increase proportionately with the increase in sales, supported an increase in net income by 15% to $100,000 and 10% to $110,000, respectively.


Advanced Analysis:


Consistency of core earnings.  Are profits consistent period to period?  One time charges need to be removed when analyzing profitability.  If the company generated a loss during one of the periods being analyzed, was it due to the start-up of a new division, branch operation or a change in the competitive landscape?


When analyzing profitability it is important to review if they are derived from continuing operations or from other activities, such as an accounting adjustment, sale of equipment, or an unusual event. When reviewing the returns, it is very important to compare the returns to investments of a like risk.  For instance, an investment in a restaurant would require a higher return than investing in government bonds.  Does profitability provide an acceptable return? Profitability is one of the most important areas of income statement analysis, as profits provide the basic motive for starting a business or continuing in business. 


Analyzing the Balance Sheet

A balance sheet lists the assets of a business and how those assets are financed.  In layman’s terms, a balance sheet provides a list of what a business has and how much and who the business owes.  Asset valuation is an important aspect of the credit analyst’s job. 





Cash -  Cash on hand, petty cash, deposit accounts, and unrestricted savings accounts.  It is what is used to pay all obligations.  When evaluating cash, the analysis should discuss the adequacy of cash to cover expenses and fixed obligations.  


Advanced Analysis: 


Ask about any restrictions on cash, like a collateral pledge. Once pledged, a CD can no longer be considered cash.   


  1. Have you had any overdrafts in the past year?  How many?

  2. How much have you paid in overdraft fees in the past year?

  3. What do you do with excess funds?


Accounts and Trade Notes Receivable


Accounts and trade notes receivable are created when a seller provides a service or a product on credit.  Analysts attempt to determine the validity and collectivity of accounts.


Key Ratios:

A/R Turnover Ratio
Dilution Rate
Bad debt expense/Net accounts receivable
Bad debt expense/Allowance for bad debt
Bad debt expense/Sales




For many companies, particularly service companies, accounts receivable may be the largest and most important asset.  Accordingly,   the analyst needs to validate the value of the accounts+ and the ability and the effort required to collect them. First, accounts receivable turnover –days should be evaluated and compared over time. Quicker is better when evaluating accounts receivable turnover. A slowdown of a couple days will negatively impact cash flow from operations.  


Bad debt expense as a percentage of sales should be evaluated. Is it increasing or decreasing?  Compare bad debt expense to the allowance for bad debt, if the company has one.  Is the allowance sufficient to cover bad debt expense?  Dilution, or adjustments to the invoice amount, should be reviewed for the adequacy of bad debt expense and the potential overstatement of accounts receivable.  Dilution includes trade discounts taken, short-pays, returns and allowances.  While they should be recognized as they occur, many businesses wait to year-end to recognize them, making interim financial statements incomplete.  Note: Many of these questions will sound familiar, as they are also pertinent to the income statement analysis.


Additional Documents Required: A/R Aging Schedule, when repayment includes conversions of accounts receivable or liquidation of collateral. 



  1. What are your trade terms? Have they changed anytime in the past year?

  2. Who are you major customers?

  3. What were your write-offs last year?

  4. Do you have any major account delinquencies?

  5. When is a sale booked or recognized?

  6. Do you have a reserve for bad debt? If so, what process do you use to determine it?

  7. Have you pledged accounts receivable to any loans?


Advanced Analysis:

Accounts Receivable provides the basis for a number of different funding vehicles. If managed, they can be a viable repayment source. If left unmanaged, they cannot be relied on to liquidate a debt. The number and intensity of controls usually have an inverse relationship to the financial strength and cash flow of the client.




Inventory is product, either purchased or manufactured meant for sale.  Inventory is the key asset for wholesalers, retailers and non-service businesses.  The primary classifications of inventory are raw materials, Work-In-Process (WIP) and finished goods.  Raw materials consist of materials used in the manufacturing process.  Raw materials are valued at their purchase price.  Work-In-Process consists of raw materials, labor and a component of overhead applied to materials still in the production process. Work-In-Process usually has minimal value for a lender in a forced liquidation scenario. Finished Goods is the inventory in its final form, after the manufacturing process is complete.  Goods purchased for resale are already in their final form.  

Inventory has a number of valuation methods under GAAP(Generally Accepted Accounting Principles).  These inventory valuation methods are important because inventory is purchased over time.  FIFO(First-In, First-Out) tends to cause  a lower cost of sales a higher inventory valuation. LIFO (Last-in, First-out) provides a higher cost of sales and a lower inventory balance.  Weighted-Average is based on the weighted average of the inventory.


For example, stainless steel bolts are purchased by ABC company at three different times. The first time, 100 bolts are purchased for $1.00 each. The second time, 200 bolts are purchased for $2.00 each and the third time, 50 bolts are valued at $5.00 each.  Assuming 200 bolts are sold during the year, what is the value of the remaining inventory? 

Extraordinary Expenses
Net Income
Accounts & Notes Receivable
Evaluating Financial Statements Table

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




  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.         



  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.




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.




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. 



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.


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.  




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

Prepaid Expenses
Fixed Assets
Accounts & Trade Notes Payable
Notes Payable
Accrued Liabilities
Long Term Debt
Capial Leases
Subbordinated Debt
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