Chapter 3 Understanding Financial Statements PDF

Home About FIN367 3.2.2.2 Understanding Financial Statements AUDITED FINANCIAL STATEMENT Statement of Financial Position Statement of Comprehensive Income Statement of Cash Flow...

Home About FIN367 3.2.2.2 Understanding Financial Statements AUDITED FINANCIAL STATEMENT Statement of Financial Position Statement of Comprehensive Income Statement of Cash Flow Financial Ratio Cash Flow from Operating Solvency Ratio Analysis Activities Gross Profits Margin Cash Flow from Investing Activities Gearing Ratio Net Operating Profits Margin Cash Flow from Financing Debts Service Activities Return on Assets Asset Management Return on Equity  Home About FIN367 3.2.2.2 Understanding Financial Statements A company’s full-year financial statements are included in its annual report. Annual report provides financial and non-financial information to the Credit Officer. The financial information includes a Statement of Financial Position (previously known as Balance Sheet), Statement of Comprehensive Income (previously known as Profits and Loss Statement), Statement of Cash Flow, Statement of Changes of Equity, and Notes to the Account. The non-financial information includes the Auditor's Report, Directors' Report, and further Notes to Account (such as the company's principal activities). For publicly listed Corporations (PLC), it also includes the Chairman's Report and Activities Report. The first step in reading the Financial Statement is to review the auditor's opinion of the financial statement. It is only acceptable if the auditor issues an unqualified opinion of the financial statement that provides assurance to the reader that the financial statement is drawn up in accordance with approved accounting standards and presents the financial position and results of the company. Next, the Credit Officer is required to read the Directors' report, followed by the respective financial information and notes to account. Directors' Report is mandatory under the Company Act. The company directors are required to attest to the true fairness of the financial position and results of the company and its ability to meet its short-term obligations subsequent to the financial year.  Home About FIN367 3.2.2.2 Understanding Financial Statements By reading directors’ reports, Credit Officers are able to access critical information pertaining to the acquisition /disposal of assets/investment, issuance of shares or debenture, and material movements in reserves or provisions within the company. Notes to accounts provide supplementary information and explanation to some contents of the financial statements. It discloses the accounting policies adopted by the company and provides a breakdown of fixed assets and stocks. This enabled lenders to assess the consistency of assets with =the nature of business, the possibility of outsourcing of production processes, and hidden reserves in the value of assets or stocks. The detailing of collateral arrangements for banking facilities under Notes to Account enabled lenders to assess their position to ensure they are pari-passu vis-a-vis other lenders. It also serves as constructive notice pertaining to negative pledges to other lenders. In assessing the notes to account, it is important for the Credit Officer to take note of post-balance sheet events that take place after the date of the Statement of Financial Position. It serves as a warning signal to the lender if any material litigation or contingent liabilities are realized subsequent to the financial period or major acquisition /disposal that may have an impact on the future business direction, profitability, and financial position of the company. The notes to accounts also disclose a company's transaction with related parties, subsidiaries, or associated companies. This should be investigated by the Credit Officer to ensure that the related party transactions are on an arm's length basis and will not give rise to the risk of capital leakage, liquidity drainage or affect the borrower’s debt repayment capability.  3.2.2.2 Understanding Financial Statements Home About FIN367 1. ANALYSIS OF STATEMENT OF FINANCIAL POSITION Prior to financial statement analysis, credit officers need to understand and relate the business operating cycle and capital investment cycle to the financial statements. This will help credit officers develop an expectation of the numbers in financial statements to be in line with the borrower's nature of business. The statement of financial position should be the first statement analyzed by the credit officer. By assessing the assets owned by the borrower, the Credit Officer will have a better understanding of the business and develop an expectation of the income that matches the assets owned by the borrower. Lender is able to assess the short-term solvency of a company by analyzing the Statement of Financial Position using current and quick ratios. The current ratio assesses the ability of the borrower to meet its short-term obligation within the next 12 months from the conversion of current assets into cash, whilst the Quick Ratio is more stringent by excluding stocks, which are assumed illiquid. Both ratios have their weaknesses as they do not reflect the company’s ongoing ability to meet its liability from cash flow generation, and their acceptability is dependent on the quality of current assets, mainly stocks and trade receivable. The long-term financial stability of a company is reflected by its level of gearing. This can be assessed by the gearing ratio (debt/equity). The acceptability of gearing varies depending on the nature of the business, industry benchmark, and type of gearing (trade, CAPEX, or advances related). The lower the gearing ratio, the higher the shareholders' financial commitment towards the company.  3.2.2.2 Understanding Financial Statements Home About FIN367 1. ANALYSIS OF STATEMENT OF FINANCIAL POSITION As a general rule of thumb, a shareholders' financial commitment over long-term assets should be at least 50%. Lenders can include quasi capital, such as the subordination of loans from related parties, and off-balance sheet items, such as third-party charges of property by shareholders/directors as indirect shareholders' financial commitment. A company with debts to equity of less than 1.0 can be considered over-geared if it is not able to service its future obligation given its current borrowings. This is measured by financial ratios such as Time Interest Earned (TIE) and debt servicing ratio (DSR). Trade-related gearing is regarded as having a lower risk of over gearing as compared to capital expenditure (CAPEX) or advance-related gearing. This is because trade-related gearing involves a shorter tenure of financing, and funds are utilized to finance transactions that generate cash flow from the operating cycle. For CAPEX-related gearing, obligations for loan payment are fixed irrespective of the borrower's cash flow generation, whilst, for advances-related gearing, the lender does not have control over the borrower's use of facility and source of repayment. Lenders can assess the funding stability of a company from the statement of financial position. Generally, the financing tenure must match the tenure of assets needs. If there is a high amount of short-term funding of long-term assets, borrowers may be vulnerable during the economic downturn when the short-term funding is withdrawn or not rolled over by the lender. This would affect the short-term liquidity and long-term solvency of the company.  3.2.2.2 Understanding Financial Statements Home About FIN367 1. ANALYSIS OF STATEMENT OF FINANCIAL POSITION To determine the efficiency of the borrower in managing its working capital assets and fixed assets, the Credit Officer can analyze assets management ratios. This category of ratios can be further classified into operational efficiency ratios and fixed assets turnover ratios. Operational efficiency ratios measure the efficiency of the company in managing current assets related to the trade cycle or terms of trade of the company. If the average collection period is longer than the credit term extended by the company, it indicates the risk of delayed collection or bad debts that can be further verified from the borrower's latest debtors aging report. An increase in stock holding period as compared to the previous financial year or longer than the industry benchmark could be a warning signal of slow stock movement, stock obsolescence, or goods rejection by customers. Fixed assets turnover measured the fixed assets productivity. Generally, the higher the fixed assets turnover, the more efficient the company's production capacity. Nevertheless, the Credit Officer needs to compare the ratio with other industry players to determine the acceptability of the ratio and conduct site visitation to verify the asset’s productivity and physical conditions.  3.2.2.2 Understanding Financial Statements Home About FIN367 2. UNDERSTANDING STATEMENT OF FINANCIAL POSITION A statement of financial position is represented by the equation: Assets = Liabilities + Capital Assets are effectively the needs of the business that are financed by the sources of cash in the form of liabilities and capital. Limitation of the balance sheet is that information is historical and static. The company may be in a stronger financial position than it appears due to the understating of historical assets’ value as compared to current market value. Balance Sheet can be used for the following analysis: Assess the extent of shareholders' financial commitment in the company relative to external creditors such as lenders and trade creditors. A quick snapshot of the company’s short-term solvency. Assess the appropriateness of the funding structure in relation to its nature of business.  3.2.2.2 Understanding Financial Statements Home About FIN367 2. UNDERSTANDING STATEMENT OF FINANCIAL POSITION Statement of Financial Position made up of various components as follows:: i. Assets o Current Assets are those that can be sold and converted to cash within the next 12 months, including raw materials and finished stocks. o Non-current assets are those that the company has no intention of selling within the next 12 months and are required to run the main business of the company. o Intangible Assets are permanent but not in physical form, such as Licenses, copyrights, brands, patents. It also includes preliminary expenses capitalized for periodical write off, eg. R & D expenses, promotional and advertisement, oil and gas exploration expenses. ii. Liabilities o Current Liabilities (CL) comprise of obligations that need to be honored within the next 12 months. It further breakdown into: Revolving CL - trade creditors, overdraft and bills payable. Non-revolving CL - current portion of term loan, HP (principal payment payable within next 12 months); tax payable, dividend payable. o Long Term Liabilities I Non-Current Liabilities comprise of obligations that need not be honored within the next 12 months e.g. Term loan, HP, deferred tax liability.  3.2.2.2 Understanding Financial Statements Home About FIN367 2. UNDERSTANDING STATEMENT OF FINANCIAL POSITION Statement of Financial Position made up of various components as follows:: iii. Share Capital/Equity o Share Capital is equity funds put in by shareholders into the business. o There are 2 classes of share capital: Ordinary Share Capital - Conveys absolute ownership rights as the shares come with voting rights. There is no assurance of dividends. Preference Share Capital - Restricted ownership rights. No voting rights. There is some dividend income assurance but not guaranteed. Nevertheless, preference shareholders have preference in both payment of dividend and par value of shares upon liquidation. iv. IV Reserves o Revenue Reserves is the profit and loss generated from daily business operation and yet to be distributed to the shareholders. It could be available for future distribution as cash dividend. o Capital Reserves arise from capital transactions and not related to profit and loss. Not available for distribution as cash dividend but can be distributed as bonus share issues to project a stronger capitalized company. Example of Capital Reserves are Assets Revaluation Reserves and Share Premium.  3.2.2.2 Understanding Financial Statements Home About FIN367 3. USING FINANCIAL RATIO TO ANALYZE STATEMENT OF FINANCIAL POSITION Financial Ratio can be used as tools to analyze Financial Statement. It is derived from dividing the dollar amount of one financial item with the dollar amount of another financial item. a) Solvency Ratio Solvency Ratio is also known as Liquidity Ratio. It assesses borrower's ability to meet short term obligations from the liquidation of its current assets within the next 12 months. It serves as margin of safety for short-term creditor. The ratio does not measure the on-going ability of the borrower to generate cash flows to meet its maturing obligations. i. Current ratio (CR) ✔ The effective use of this ratio is on the assumption that current assets is of good quality. CR = Current Asset / Current Liabilities ✔ Low ratio indicates borrower's inability to meet short term obligations from the liquidation of its current assets. ✔ Too high ratio may indicate inefficient in assets management such as slow sales collection, credit control policy is too liberal, overstocked or slow-moving stocks.  3.2.2.2 Understanding Financial Statements Home About FIN367 3. USING FINANCIAL RATIO TO ANALYZE STATEMENT OF FINANCIAL POSITION a) Solvency Ratio ii. Quick Ratio or Acid Test Ratio Acid Test Ratio = (Current Asset – Stocks) Current Liabilities ✔ The ratio is a more stringent test than Current Ratio. ✔ It assumes that the short-term obligations need to be paid back in a time period shorter than 12 months, and stocks are considered the most illiquid of the current assets. iii. Gearing Ratio Debt/Equity Ratio= Total Liabilities / Total Shareholders’ Equity ✔ Measures the reliance on external debts by borrower relative to internal shareholders' equity. ✔ It questions the sufficiency of financial commitment from shareholders. ✔ The lower the ratio, the lower is the proportion of financing provided by external creditors and the greater is the commitment of shareholders. ✔ Gearing comes with obligation to honor debts commitment irrespective whether borrower is doing well or not. It does not assess borrower's ability to pay the debts obligation which is measured by debts servicing ratio  3.2.2.2 Understanding Financial Statements Home About FIN367 3. USING FINANCIAL RATIO TO ANALYZE STATEMENT OF FINANCIAL POSITION Financial Ratio can be used as tools to analyze Financial Statement. It is derived from dividing the dollar amount of one financial item with the dollar amount of another financial item. a) Solvency Ratio iv. Debt Service Ratio ✔ Debts Service Ratio assess the creditworthiness of borrowers in relation to their ability to service their debts. It indicates whether the borrower is over-geared. Times Interest Earned Ratio (TIE)= Earning Before Interest and Tax Interest Expense ✔ It indicates borrower's ability to service periodic interest payments from its current profits. ✔ The higher the ratio, the greater the assurance that interest will be paid. ✔ For working capital facilities, TIE ratio should be read together with Quick Ratio to gauge borrower's ability to meet short-term repayment demands. Debt Service Ratio = Earning Before Interest and Tax (Interest Expense + Principal Repayment) ✔ Applies to term loans only and not suitable for working capital (WC) facilities like overdraft and trade facilities. ✔ A low ratio reflects weak profits performance, higher borrowings cost and risk in meeting principal instalments.  3.2.2.2 Understanding Financial Statements Home About FIN367 3. USING FINANCIAL RATIO TO ANALYZE STATEMENT OF FINANCIAL POSITION b) Assets Management Also known as the efficiency ratio, asset turnover or activity ratio. It measures efficiency in managing Current Assets that are related to trade, and efficiency in managing Fixed Assets productivity. i. Average Collection Period Average Collection Period = Average Trade Debtors Balance x 365 days ✔ Also referred to as Debtors Turnover. Credit Sales ✔ It measures how long on average it takes to collect trade receivable after sale has been made. ✔ It is compared with the credit policy granted by the company to indicate the effectiveness of credit control system and efficiency of collection process. ii. Average Stock Holding Period Average Stock Holding Period = Average closing stock Balance x 365 days Cost of good sold ✔ It measures how long stock items remain in the store or shelf before it is finally used or sold. ✔ Measures stock adequacy and efficiency of stock management. ✔ A longer stock holding period (as compared to industry norm) reflected risk of stock obsolescence, slow moving stocks, tight liquidity and higher working capital requirement.  3.2.2.2 Understanding Financial Statements Home About FIN367 3. USING FINANCIAL RATIO TO ANALYZE STATEMENT OF FINANCIAL POSITION b) Assets Management iii. Average Payment Period Average Payment Period = Average Trade Creditors Balance x 365 days Purchases or cost of good sold ✔ It is also referred as Creditors Turnover Period. It is closely associated with business operating cycle. ✔ It is the average period of credit taken by borrower from its suppliers or trade creditors. ✔ Average payment period that exceed the supplier's credit term indicated poor liquidity and risk of future supplies terminated by suppliers. iv. Fixed Asset Turnover Fixed Assets Turnover = Sales Average fixed Assets ✔ This ratio measures the efficiency with which the fixed assets have been employed to generate the sales. ✔ The higher the ratio, the more efficient the assets are being employed. ✔ Low fixed assets turnover ratio indicated idle production, Low fixed assets productivity or expansion of capacity not filled up yet where benefits may be reaped in later years. ✔ Too high fixed assets turnover ratio indicated possible machinery overwork with risk of breakdown that may compromise products quality.  3.2.2.2 Understanding Financial Statements Home About FIN367 4. ANALYSIS OF STATEMENT OF COMPREHENSIVE INCOME The key areas of analysis of Statement of Comprehensive Income are to gain insight into the quality of the company's profitability and its future profitability. Borrower's operating performance is measured by Gross Profits Margin and Net Operating Profits Margin. The operating performance is considered of good quality only if bulk of the profits for the year are derived from core business. Therefore, it is important for Credit Officer to exclude non-operating income such as gain from disposal of assets, assets valuation gains and dividend income which are non-recurring in nature in their operating profits analysis. The economy context in which the operating performance is achieved will also determine the quality of profits. A company that generates weaker operating profits during economy downturn where other players suffered losses can be considered having good quality operating performance. To assess the sustainability of the company's future profitability, credit officers must be aware of the company's bread and butter e.g., sales mix in terms of products, departments or geographical spread. This will help to assess the impact of adverse performance of any one of its flagship products or department to the company's future profitability.  3.2.2.2 Understanding Financial Statements Home About FIN367 4. ANALYSIS OF STATEMENT OF COMPREHENSIVE INCOME In addition, an understanding of critical cost component and factors affecting the fluctuation of these cost (such as supply restriction, oil price increase), as well as borrower's bargaining power as a buyer will enable lender assess the impact of these cost increase to the company's future profitability. The Return of Assets also known as Return on Investment (ROI). It measures how efficiently the company's assets have been used to generate profits for the company. It also determines how well the company uses all available resources such as capital and debts in running its operation. The higher the ratio, the more effective is borrower and its management in using its assets or resources. When ROA is lower than cost of borrowings and cost of equity, it indicates poor assets investment or poor ability to use asset resources. It represents a greater risk to lender as the company is financially weak and required shareholders' continuing capital commitment to support the management’s Inefficient use of assets and resources. Return of Equity (ROE) measures the risk and reward to shareholders of the company. Shareholders are investors in the company who seek reasonable profits for the equity risk they underwrite by investing their capital. A high-risk company with low ROE should be avoided by lender since shareholders’ commitment to the company may not be assured in time of crisis.  3.2.2.2 Understanding Financial Statements Home About FIN367 5. UNDERSTANDING STATEMENT OF COMPREHENSIVE INCOME Statement of Comprehensive Income is a report card of the performance of the management. It is linked to Statement of Financial Position where any profit not paid out as dividends will be added to the shareholder's equity. Any losses will reduce the shareholders' equity. A company will incur expenses in the course of its business to generate revenue. The expenses that are matched against revenue in the same period where they are incurred is known as revenue expenses. However, there are instances where expenses can be taken into account on an accrual basis. Capital expenses such as CAPEX for machinery, R & D expenses can be carried forwarded to set off against future revenue and spread over different accounting periods. A portion of this expenses is recorded in each accounting period in the form of assets depreciation. i. Revenue ❑ There are 2 classes of revenues: i. Operating revenue relates to the income generated from the core business. ii. Non-operating revenue relates to income generated but not from its core business. It is important to note if such income is recurring. For example, gain from assets sales, assets revaluation gain, foreign exchange translation gain, write back of bad debts provision etc. are nonoperating revenue which is non-recurring in nature  3.2.2.2 Understanding Financial Statements Home About FIN367 5. UNDERSTANDING STATEMENT OF COMPREHENSIVE INCOME A portion of this expenses is recorded in each accounting period in the form of assets depreciation. ii. Expenses ❑ Expenses can be classified into the following categories: i. Cost of Goods Sold - costs that are directly involved in the products sold. For example, raw materials, direct labor cost, shipping, port charges. ii. Operating expenses - related to expenses incurred in the ordinary course of the business. For example, salaries, utilities, depreciation, sales and marketing expenses, finance expenses. iii. Non-operating expenses - related to expenses incurred but not directly related to the business. For example, legal fees, insurance compensation.  3.2.2.2 Understanding Financial Statements Home About FIN367 6. USING FINANCIAL RATIO TO ANALYZED STATEMENT OF COMPREHENSIVE INCOME i. Gross Profit Margin (GPM) GPM = Gross Profit x 100% Sales GPM represents the amount in excess of cost of goods sold that is available to meet the variable and fixed operating expenses. High risk and cyclical industry usually command higher gross profits margin (GPM) as compared to stable low risk industry. For example, airline, construction, electronic and electrical industries have higher GPM as compared to rice, F&B, stationery industries. GPM of a business can be influenced by the company's pricing practice; cost efficiency in production and purchasing; products mix; Foreign exchange gain /loss arising from purchase/ sales of products in different currency and market. ii. Net Operating Profit Margin (NPN) It reflects the profitability of business after takingOPM into=consideration EBIT x 100%all expenses or costs incurred. Sales Business within NOM is susceptible to fluctuation in sales volume, price competition and cost escalation. For example, supermarket chain, steel industry etc. NOM can be affected by factors that affect gross profits margin; Selling, General and Administrative expenses of a company and financial expenses of a company. Acceptability of GPM and NOM depend on the nature of business and industry.  3.2.2.2 Understanding Financial Statements Home About FIN367 6. USING FINANCIAL RATIO TO ANALYZED STATEMENT OF COMPREHENSIVE INCOME i. Return on Asset (ROA) ROA = EAT x 100% Average Total Assets This is also referred to as Return on Investment (ROI). ROA measures the effectiveness in which assets have been employed to generate profits for the company. The higher the ROA, the more effective is borrower and its management in employing their business assets and financial resources. To improve ROA, business can explore assets stripe. For example, to get rid of unproductive assets and increase profits generated from existing productive ones. ii. Return on Equiuty(ROE) ROE = Net Profit after Tax x 100% It reflects the risk to reward for shareholders. Shareholders’ Equity It measures the returns in relation to the equity funds contributed by ordinary shareholders. ROE can be boosted by business profitability, financial leverage /gearing and assets productivity. Borrower with low ROE is higher risk for lender as shareholder's financial commitment is less assured.  3.2.2.2 Understanding Financial Statements Home About FIN367 7. ANALYSIS OF STATEMENT OF CASH FLOW Statement of Cash Flow provides an understanding as to the size of cash, sources of cash and how cash has been used. While the company may be profitable, it does not necessarily mean that the company is healthy in cash flow. This is due to accounting principle of Accruing where revenue reported in the accounting period may not be received yet, while expenses incurred in the accounting period, may be paid in a different accounting period. Statement of Cash Flow needs to be analyzed together with Statement of Comprehensive Income and Statement of Financial Position in order to understand the cash flow implication of profits and losses, and balance sheet. The analysis of Statement of Cash flow involves analyzing each activity in the cash flow statement. Cash flow from Operating Activities (CFO) assesses the main source of cash generated from a company's day to day operation. It comprised of Net Profits After Tax and is adjusted for non-cash items such as depreciation and gain from disposal of assets. CFO also reflects the efficiency in managing the company's daily net working capital. An increase in net working capital representing application of cash whilst a reduction in net working capital representing source of cash. A negative CFO is acceptable provided the negative (application of cash) is not for prolonged period, not too huge relative to the size of business, and the negative CFO is not caused by inefficiency in working capital management that led to widening of financing gap.  3.2.2.2 Understanding Financial Statements Home About FIN367 7. ANALYSIS OF STATEMENT OF CASH FLOW i. Cash flow from Investing Activities (CIN) CIN provides information on strategic decision of the company pertaining to fixed assets /CAPEX investment and business investment. A high negative CIN indicated business is expanding its capacity to accommodate future growth or embarking on an acquisition of strategic investment. A low negative or positive CIN indicated that business has not fully utilized its capacity or is going through a period of consolidation or divesting its investment that may not fit corporate strategy. ii. Cash flow from Financing Activities (CIF) CIF provides information on the funding position of the company. A positive CIF indicated source of funds from loan drawdown or capital injection to finance the deficit in CFO and CIN. A negative CIF indicated use of funds for repayment of loan or dividend payment from the surplus funds derived from CFO.  Home About FIN367 3.2.2.3 Quantitative Analysis of Financial Statements Quantitative analysis is another important part of business credit analysis. It involves analyzing the Past and future earning capacity of the company, long-term stability of financial position, and sustainability of cash flow generation. In quantitative analysis, the focus is on the assessment of both historical and forecast financial information to make risk judgments on future cash flow. Statement of Comprehensive Income provides historical information on the company's revenue and costs, operating margin, and also, its competitiveness as compared to industry peers. Credit Officers are required to analyze the quality of earnings generated from the borrower's core business, the critical cost components, and bread and butter products/business divisions that would affect the sustainability of the borrower's future earnings. Statement of Financial Position provides a summary view of the company's historical financial position. It provides information such as the short-term liquidity position of the company, appropriateness of funding structure and possible risk of insolvency, and risk of over-gearing and over-trading. It also measures management's ability to manage the working capital and capital expenditure/long-term assets efficiency.  Home About FIN367 3.2.2.3 Quantitative Analysis of Financial Statements Credit Officers can make such assessments through financial ratios such as current ratio, gearing ratio, and assets efficiency ratio to be derived from the borrower's statement of Financial Position. Statement of Cash Flow indicates the liquidity position of the company through the source and application of cash in the borrower's business. It explains the components of cash flow generation from day-to-day operating activity and assesses the borrower’s debt servicing capacity. It also provides information on the company's investment and financing activities during the period under review. The continuing viability of the company and its capacity to generate future cash flow is of great concern to the credit officer. Audited financial statements do not reflect the company's latest financial position. Therefore, there may be a need for the Credit Officer to request a Financial Forecast that covers the revenue, costing, and cash flow projection for the future period. To ensure the financial forecast is realistic, Credit Officers are required to review the basis of assumptions and modify where necessary to assess the risk implication as a result of changes in key financial variables. To ensure the viability of the collateral and guarantor as a second way out, a qualitative and quantitative assessment of the collateral or financial condition of the guarantors would be required. This is to ensure that the collateral has sufficient net realizable value or guarantor has the financial means to cover the loan exposure when the need arises.  Home About FIN367 3.2.2.4 Qualitative Aspect of Financial Statements Business credit analysis is an extensive assessment of a borrower's business activities, key risk issues, and its current or future funding requirements. This analysis forms a major section of the bank's credit proposal. The assessment involves a Qualitative Analysis of the borrower's business and operating environment by assessing the internal and external factors. In this analysis, the lender needs to identify the borrower's key business risks and success factors that are critical for a sustainable business and potential cash flow generation. In conducting Qualitative Analysis, the Credit Officer can use tools such as SWOT analysis (Strengths, Weaknesses, Opportunities, Threats) to have a better understanding of the borrower's business and enhance the credit decision-making process. SWOT Analysis is based on the principle that a company’s business strategy must produce a strong fit between a company's internal capability (its strengths and weaknesses) and its external situation (opportunities and threats). There are several key areas to be assessed under Qualitative analysis. It started with the analysis of the key management team, who is critical in steering the company towards success and managing internal and external risk factors of the company.  Home About FIN367 3.2.2.4 Qualitative Aspect of Financial Statements The internal factors to be analyzed under Qualitative analysis involve the entire operating cycle of a business from supplier, manufacturing process, products, and customer (sales and distribution) to collection. Credit Officers are required to identify the strengths and weakness of the borrower's internal capability, business risks that will affect cash flow generation of the operating cycle, and mitigation factors that have been put in place by management. In addition, lending covenants and other control measures can be proposed by the lender to mitigate the respective business risk identified from the borrower’s operating cycle. Industry competitiveness is the external factor to be analyzed under Qualitative analysis. In this section, the lender needs to understand the macro-environmental factors changes and their impact towards business viability, as well as assess the management's capability in taking pre-emptive measures and strategies to counter the external threat and capitalize on the external opportunities.