© 2000 John Petroff
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© 2000 John Petroff |
B- Analytical methods of financial statements
The type of analytical method, the extent of the investigation and the sources of information used, depend on the type of relationship that exists between the analyst (or decision maker) and the firm. Since lenders are protected by borrower's promise to pay principal and interest on time, their main inquiry will focus on the firm's ability to meet these obligations. Thus, an emphasis will be put on short run liquidity. Shareholders will be more interested in long run growth and solvency of the firm. Neither point of view should, however, exclude the other because a lender ought to look at the borrower as a prospective client for many years to come, and a shareholder would obviously be immediately affected should the firm be unable to meet its current obligations and be forced to close down.
There are three levels of analysis
to be distinguished:
1)- Screening: it consists in accepting
or rejecting prospective firms on the basis of one or a set of
ratios; two methods are common:
- discriminant analysis: it may use a single criterion, such as
a liquidity ratio, or a multiple criteria set; the latter may
involve the use of linear programming;
- credit scoring: a rating is calculated
by combining quantitative and qualitative information for each
firm, and firms are selected above a certain grade or score.
2)- In depth analysis is conducted on
those firms that have been accepted in the screening process,
as well as on a few border line firms; it requires a large volume
of information from the firms; the outcome of the analysis may
be a loan approval, a merger or a stock subscription.
3)- Tracking: it consists in a continuous
review of firm's performance, and it usually requires predictive
skills of a financial analyst (in stock brokerage firms, in particular).
In the credit department of a bank, the analysis may be automated
and a recalculation and screening of ratios by computer may be
performed on a quarterly basis.
See review questions Q-5B.1 through Q-5B.5.
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