A business’s financial statements generally contain detailed information about its assets, liabilities, income, and expenses. Scrutinising these statements helps understand the intricate workings of an organisation and helps assess its financial stability.
Financial statement analysis often forms the bedrock for informed decision-making for various stakeholders. It offers insights into the business’s financial health to investors, business owners, and lenders and holds special significance for lenders.
Lenders always want to minimise their risk when they sanction loans; for this, they employ various strategies and tools, and financial statement analysis is one of them. This blog post focuses on better understanding the financial statement analysis process and its utility for lenders.
What Is Financial Statement Analysis?
Financial statement analysis involves examining a borrower’s financial statements to evaluate their financial health and determine their creditworthiness.
A comprehensive financial statement analysis is instrumental in identifying potential red flags and helping lenders make decisions consistent with their lending policies.
The analysis is like a diagnostic tool that assists in making rational and objective business decisions.
The raw financial information from the financial statements is thoroughly analysed to transform it into usable information. Bank statement analysis provides an accurate assessment of the applicant’s financial history.
Financial Statement Analysis: The Components
Financial statement analysis involves evaluating the following:
- Balance Sheet
The balance sheet of a business has details of its assets, liabilities, and equity. It is a snapshot of an applicant’s financial situation at a particular time.
- The Income Statement
The income statement measures the operating performance of a business for a specified period, usually a financial year. It has detailed information about the revenue earned and expenses incurred by the organisation over a period.
The income statement also reveals how a company performed in the past year, while the balance sheet illustrates the wealth of a company; both offer different and complementary information about a company.
- Statement of Retained Earnings
This statement is also known as a statement of changes in equity; it reflects changes in the retained earnings over the reporting period. The statement includes details on profits or losses from operations, dividends paid, shares issued or redeemed during the period, and any other items charged or credited to retained earnings.
- Cash Flow Statement
The cash flow statement provides information about the inflows and outflows of cash not included in the balance sheet and the income statement. It is a detailed transaction log that helps offer lenders insights into the company’s liquidity and cash management capabilities.
How Does the Financial Statement Analysis Help Lenders?
Automation and technological innovations over the years have helped lenders improve their overall efficiency and functioning. Lenders can incorporate financial statement analysis into their lending process using innovative digital tools to improve their overall profitability.
Analysing the financial statements of an applicant offers the following benefits to the lender:
1. Better Assessment of the Borrower’s Creditworthiness
A business’s financial statements offer insight into profitability, liquidity, solvency, and efficiency. All these aspects help the lender assess if the business can manage its long- and short-term obligations and repay its loan instalments. Analysing these metrics helps lenders assess the borrower’s creditworthiness and minimise the risk of loan defaults.
2. Offer Customers Risk-Based Pricing and Terms
When borrowers apply for a loan, they pay interest on the borrowed amount. Banks charge interest to cover the credit risk of default they undertake when they sanction a loan.
Financial statement analysis helps lenders have risk-based pricing for loans for their customers. Using the inputs from the analysis can help banks design repayment terms for the applicants based on the insights and offer differential pricing. Lenders can also provide tailor-made solutions per the borrower’s specific risk profile, ensuring benefits for the lender and the borrower.
As a result, lenders obtain appropriate compensation for undertaking the risk, while creditworthy borrowers gain from more favourable terms designed to suit their risk profile.
3. Foster Stronger Customer Relationship
The financial statement analysis can also be instrumental in strengthening lender-borrower relationships. Lenders can offer their customers customised solutions and support if they identify potential challenges during the analysis.
They can offer the applicants the most suitable loan types, interest rates or repayment schedules based on their requirements and financial strengths and weaknesses.
4. Improved Portfolio Management
Lenders must manage their portfolios and optimise their performance to improve profitability.
Financial statement analysis can help identify customers with different risk profiles across industries by evaluating their statements and helping lenders diversify their portfolios.
Lenders can reduce dependence on a specific sector or industry and minimise vulnerability during an economic downturn. Also, they can have a more resilient and balanced portfolio by improving decision-making regarding portfolio diversification and risk allocation.
5. Proactive Loan Management
Financial statement analysis can help lenders at all stages of the loan lifecycle, from loan application screening to monitoring collections. It helps lenders pick early warning signs of instability. Indicators like falling profitability, rising debt levels or poor cash flow management are some red flags that can draw attention.
This information can help lenders act proactively and take required measures. They can design strategies to ensure better management and collection of debt and mitigate risks. Monitoring a borrower’s financial health regularly and accurately can help reduce risks and improve collections for the lender.
Key Takeaways
Financial statements are a gold mine of data that can offer lenders valuable and actionable inputs at different stages of the lending lifecycle. Banks can improve their screening process at the time of loan application.
Lenders gain a deeper insight into the applicant’s financial health, which helps them improve their credit assessment and collections. Improved customer relations, better portfolio management, and the ability to offer risk-based pricing to customers are additional benefits of analysing financial statements.
Finezza’s bank statement analysis tool is a helpful solution that helps lenders manage their credit risk. A bank statement analysis report provides comprehensive insight into the applicant’s financial health and can be part of the overall financial statement analysis or used individually by lenders.
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