Suppose you could only have one financial statement of a company and had to rely on that to justify a loan. Which statement would you analyze and why?
This is not my area of expertise, but I’d probably go with the cash flow statement. Debt service should come first out of cash flow. Things like collateral and equity reserves and the kinds of things that you see on the balance sheet are really only important in cases where there isn’t the income to cover debt interest. If there’s enough cash flow and it’s reliable, the other stuff doesn’t matter so much. Debt can usually be rolled over at the end if necessary.
Cash flow statement is preferable to income statement because it is harder to manipulate through wierd ways of depreciation, recording recievables, handling inventories, etc.
Obviously you’d want the other statments to get a more complete picture, but I’d say if you could only have access to one statement, the most important info would be on the statement of cash flows.
Curious if others agree with me here.
Thanks for responding bchad.
I mostly agree with you but here’s what sort of gets me: Wouldn’t the balance sheet show you a) how you’d get your money back in a worst case scenario (i.e. you declare bankruptcy the day after I lend to you) and b) other liabilities more senior to me that may not yet have shown up on the cash flow statement?
Like you, curious to hear what others have to say.
Yes, that’s true, but that’s the worst case scenario. But the worst case scenario is not as relevant if the most likely scenario is that there is lots and lots of cash flow out of which to service the loan. If there isn’t enough cash flow to service the loan, then you start to get worried about stuff, and start looking at what kind of collateral is available and where you are in the capital structure.
Obviously, in real life, you’d want to see the B/S too, for the reasons you mentioned, but you mostly care about B/S stuff when you start have doubts about whether the cash flow is sufficient or whether it is unstable.
As for whether there are other liabilities, they should show up in the cash flow statement as debt service of some sort (unless they are contingent liabilities, in which case there’s really no way to do the analysis without seeing all of the statements). You could ask, “what if they loaded up on debt the day before they came to me and I can’t see it,” but in that case it probably wouldn’t be showing up on any of the statements (in theory it shows up on the B/S, but are you really going to have access to a B/S that’s updated daily?
To some extent, if you have two B/S, I suppose you can try to back out what the cash flow is, and that would perhaps give you a bigger overall picture of earnings and equity cushions and collateral. I can see that argument.
I guess it’s unclear whether you mean we have access to only one TYPE of statement (but have it over multiple periods), or just one COPY of one statement.
Good points.
I guess I imagine this question where you have access to just one COPY of one statement. Obviously not a real world situation…or at least I hope not.
Balance Sheet. If there are quality assets, issue a 1st lien secured loan. That’s the only way to justify a loan with just one financial statement.
This.
If I have cash flow of zero but quality assets worth ten bagilliony dollars you will make me a loan and not think twice about it. The cash flow statement becomes much more critical when the loan to asset ratio is not as favorable or if the asset quality is not as certain, as that becomes a second form of coverage to pay back the loan. But if you have ten bagilliony dollars of assets it doesn’t matter.
bchad makes some good points and he is correct that cash flow is a very important consideration for traditional loans outside of my absurd scenario, but the bottom line with making loans is that you want to know you are standing on firm ground (rule 1 is don’t lose money), and that’s the balance sheet.
I see the argument in favor of the balance sheet, and it makes sense to me. Thanks for the perspective.
If you know they have quality assets to pledge as collateral, you simply demand the appropriate collateral and make the loan, it almost doesn’t matter what the CF is as long as it’s properly secured. I hadn’t thought of it that way.
+1 on the balance sheet. In addition to the tangible book value of the assets it will show you the changes in retained earnings over time. A cash flow statement is mostly a derivative of the balance sheet a lot of the useful information can be obtained from the balance sheet.
Balance sheet for reasons mentioned above. You can get a view of the capital structure to see whats outstanding (assuming you get the supplemental notes with the statement) as well as asset coverage. At least this is how I would look at it through the eyes of default risk. If there isnt sufficient assets then I think the CF statement becomes very important for debt servicing ability which is likely what you were initially thinking.
In what context? Lending based on collateral values (balance sheet) should be a very salient error given what we just went through. . .
If you have a first, perfected a lien, and have sufficient collateral coverage, I’m under the impression a lender is more concerned with cash flow statement. I’m exposed to loans made by banks on a daily basis, but am still learning.
And the context is important, as this sounds like a job interview quesiton you are seeking feedback on.
It is true that if you have to collect your collateral because of default, there are likely to be substantial transaction costs, plus reinvestment risk (less concern on that if we are entering a rising interest rate environment). I guess it ends up being about how easy it is to get your hands on the collateral and liquidate it if you need it.
Ultimately, lending is really about 1) the ability to service the loan, which is a cash flow (and maybe covenants) issue, and 2) the likelihood of getting your principal back if something goes wrong, which is what collateral and the balance sheet is about.
Fortunately, in a real world situation, you will have access to both statements, so maybe the question really gets to whether one prioritizes 1) or 2) in your underwriting practice. I can see the argument for “principal comes first,” because it’s the largest portion of the loan, but if the evidence is that there will be no problem servicing it, you presumably can sleep easier.
I think this is a very hypothetical question, but to everybody that is saying BS, nobody in the real world gives a loan based on a default scenario, i.e. exercising the rights to an asset in a bankruptcy court.
Banks have equity collateral that go through the roof if an asset is deemed impaired.
So you need to consider the ability for the company to service its loan through cash generation. Although you need to put into perspective that bullet loans are usually refinanced.
Yeah if there is a balloon payment and the company has a strong balance sheet, you can assume it will get refinanced in nearly any credit environment, including the depths of 2009. I don’t think it’s that hypothetical. If the asset quality is very good and the coverage relative to liabilities including the loan is very high, it will be easy to get a loan.
You could take the example of a person instead of a company. Zuckerberg has millions of equity in facebook. Even if he works for a total compensation package of $1 (i.e., effectively no cash flow) he could easily get a loan in any scenario. In fact I think he may have gotten a loan to pay taxes from the IPO.
IMO balance sheet is still the only sensible answer although I think the question is flawed and in reality banks would look at the balanace sheet and the cash flow statement (and in fact look at the P&L too because many loan agreements are based on pro forma adjusted EBITDA).
^^
Yes this is correct. Most corporate loan contracts are rather focused on Net Debt/EBITDA, in which case you wouldn’t even need the CF statement.
In my experience, even in CF oriented financing like LBO financing, covenants involving FCF are usually derived from the P&L and B/S with a formula, they are not taken from a CF statement.
But this is just how it is done in practice, at least in continental Europe. If it was my money, I wouldn’t invest a cent without seeing the evolution of the cash-flow generating ability of the company.
Yes, that’s right, standard corporate loan agreements are oddly focused on the P&L with EBITDA as a proxy for cash flow even though any second year analyst (if not first year or even recent grad) knows that EBITDA is really a poor measure for cash flow for many companies. Standard covenants are debt / adjusted EBITDA, minimum cash in hand (regardless of net debt level), fixed charge coverage ratios, interest coverage ratios, etc. Most or all of them triangulate toward cash flow but oddly are not directly based on actual cash flow, just proxies for cash flow.
So I guess if we had to pick a rank from this somewhat arbitrary question it would actually be:
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Balance sheet
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P&L
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Cash flow statement
I hate EBITDA. I have never understood how this metric has become so influential in the investing Wall Street community. It is such a poor proxy for actual cash flow it is sometimes laughable. I always look at CFO to account for working capital items and then account for maintenance capex to derive true cash flow generating ability of a business.
It became influential during the LBO boom during the 1980s when debt was cheap and people wanted to justify deals any way they could. EBITDA is literally “the metric that Wall Street uses to overpay” (particularly in the largely non-value creating world of private equity) – that doesn’t mean it can’t ligitimately be used in some cases, just that you have to adjust for the many real cash uses embedded in there. It would be most relevant for a company with zero debt, lots of NOLs, capex = DA where both are low, and the EBIT is positive (and preferably materially above zero). I generally use EBIT, FCF, EPS and Sales when valuing companies but it depends on the industry and the specifics involved (EV / sales is actually among the most predictive and least understood).
I agree that EBITDA is a pretty shitty proxy for CFO, but I don’t think that people use it like that.
It’s rather used for benchmarking.
US lending banks use it like that every day, I don’t know about in Europe. Almost every single bank loan in the US involves at least one covenant referencing bank adjusted EBITDA and to get a loan you have to submit detailed models to the bank that include EBITDA projections.