Lending 101 - Simplified Income Statement Analysis

Putting pieces of information together and making sense from numbers are key skillsets of a credit adjudicator. Information can sometimes be very fragmented, and numbers by themselves may not make much sense. In these situations, it is helpful to go back to the fundamentals of financial analysis.

Rule #1: Analyze revenue based on its components, i.e. price and quantity. Taking oil and gas producers as an example, many expected a negative impact on their top line due to crude oil price being at extreme low points in 2020. However, it is also important to find out whether production volume has increased/suspended. An increased production volume partially offsets the price impact and mitigates the negative effect on revenue.

Rule #2: Identify fixed and variable costs, and find out their percentage of total costs. This information might not be that straightforward from financial statements. Costs that increase with revenue are variable, while those that do not change based on production are fixed. Companies with significant fixed costs (another indication can come from a significant balance in their "Property, Plant & Equipment" line on balance sheet) are considered to be capital intensive, and would have a minimum "sales target" to achieve so that the entire cost can be recovered; this makes them less nimble during bad times. Credit adjudicators like to ensure that there is sufficient liquidity/tangible net worth with companies with high fixed costs, to ensure they have the ability to withstand industry/business shocks.

Combining the above with the revenue generation model helps indicate whether the company has good debt service-ability. Lenders like strong, recurring revenue: a typical long term take-or-pay contract (which provides certainty to both price and quantity) means a lot to ascertain a borrower's good credit quality. However, it is rare to see that in most industries. Borrowers with a volatile top line and relatively large fixed costs are less desirable. Having said that, companies that demonstrate an ability to hedge against downturns - say, those with a track record in executing successful hedging strategies, maintaining low leverage, saves up a lot of cash and attractive to investors in public market to raise capital - can serve as effective mitigants to its inherent credit risks.