Accounting and Financial Statement Analysis for Credit Decisions
Accounting and financial statement analysis asks you to read a balance sheet the way a sanctioning authority does - not to admire profit, but to test quality of earnings, liquidity, leverage and debt-service capacity.
The three statements
- Balance sheet: assets = liabilities + equity. Read classification carefully - capital versus revenue expenditure, tangible versus intangible assets - and never skip contingent liabilities in the notes.
- Profit and loss: separate operating income from other income; check EBITDA quality and extraordinary items.
- Cash flow: operating, investing and financing. A profitable firm can still default because profit is not cash.
Ratios that decide files
Current ratio (CA/CL), quick ratio (excludes inventory and prepaid expenses), debt-equity, interest coverage (EBIT/interest), DSCR, ROCE, inventory and debtor turnover, and the working-capital cycle.
Worked example
Current assets are ₹40 lakh, including inventory ₹15 lakh and prepaid expenses ₹2 lakh; current liabilities are ₹20 lakh. Current ratio = 40/20 = 2.00. Quick ratio = (40 − 15 − 2)/20 = 23/20 = 1.15. The firm looks comfortable on the current ratio, but more than a third of its liquidity sits in stock, so a slow-moving inventory problem would drag the quick ratio toward 1.0 - a warning the current ratio hides.
Traps
- Counting prepaid expenses as quick assets.
- Substituting PAT for cash accrual when computing DSCR.
- Including revaluation reserves in net worth for debt-equity without disclosure.
- Missing window dressing near the balance-sheet date: year-end collections, stretched payables, bills discounted.