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Day 2 IPCC M2 - Basic Accounting and Financial Statement Analysis

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Day 2 IPCC M2 - Basic Accounting and Financial Statement Analysis

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aisyahsaad62

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ISLAMIC PROFESSIONAL CREDIT

CERTIFICATION (iPCC)

MODULE 2: FUNDAMENTALS IN CREDIT OPERATION

Presented by:
Haji Abdul Rahman Mohd Yusoff
IBFIM Trainer

Copyright © IBFIM 2024. All Rights Reserved 1

BASIC ACCOUNTING
&
FINANCIAL STATEMENT ANALYSIS

Copyright © IBFIM 2024. All Rights Reserved 2

LEARNING OUTCOMES
At the end of the programme, the participants will be able to:

1. Describe general accounting and financial statements in Islamic

banks.
2. Explain the quantitative and qualitative analysis of financial
statements and able to interpret its literal meaning.

Copyright © IBFIM 2024. All Rights Reserved 3

LEARNING TOPICS
Topic 1: General Accounting Topic 2: Understanding Financial Statements
Principles and Policies
• Accounting Practices and Doctrines • Components of Annual Reports
• Accounting Principles • Fundamentals of Balance Sheet
• Other Accounting Principles • Fundamentals of Profit and Loss Statement
• Accounting Policies • Fundamental of Cash Flow Statement
• Limitations of Financial Statement

Topic 2: Quantitative Analysis Topic 2: Qualitative Analysis

• Overview • Overview
• Shariah Compliance • Shariah Compliance
• Framework of Analysis • Compliance to the Financing Parameters
• Balance Sheet (Financial Position) • Know Your Customer
• Income Statement (Earning Position) • Fact Analysis
• Cash Flow Statement (Liquidity Position) • External Analysis
• Ratio Analysis • Internal Analysis

Copyright © IBFIM 2024. All Rights Reserved 4

TOPIC 1
GENERAL ACCOUNTING PRINCIPLES AND POLICIES

Copyright © IBFIM 2024. All Rights Reserved 5

ACCOUNTING
❖ Generally, can be defined as “the process of identifying, measuring
and communicating economic information in order to permit
informed judgement by the users of information”.
❖ Is the system that measures business activities, process that
information into reports, and communicates these findings to
decision-makers.
❖ Accounting is shaped by the environment in which it operates.
❖ Need to comply with the accounting standards of the countries they
operate in or raise finance in – according to local requirements too.

Copyright © IBFIM 2024. All Rights Reserved 6

ISLAMIC ACCOUNTING
❖ Can be defined as the accounting process which provides appropriate information,
not necessarily limited to financial data, to stakeholders of an entity which will
enable them to ensure that the entity is continuously operating within the bounds of
Shariah (Islamic law) and delivering on its socio economic objectives.

❖ Is also a tool, which enables Muslims to evaluate their own accountabilities to God
(in respect of inter-human / environmental transactions).

❖ The purpose and the need of which is driven by the Muslims’ belief in the hereafter.

❖ Information useful to make economic or social decision through a moral framework.

Copyright © IBFIM 2024. All Rights Reserved 7

CONVENTIONAL ACCOUNTING
❖ Defined to be the identification, recording, classification, interpreting and
communication of economic events to permit users to make informed decisions
(AAA, 1966).

❖ Extended as: “to permit informed decisions which will enable scarce resources to be
allocated efficiently thereby achieving social welfare” (AAA, 1975)

❖ Ultimate purpose is to efficiently allocate scarce resources available to their most

efficient and profitable uses by providing information efficiency to the market (FASB,
1978)

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ACCOUNTING
a process of

recognising, recording,
measuring, analysing, reporting &
classifying and
interpreting result of presenting financial
summarising business
operation position
transactions

Philosophic filter (Shariah and Islamic accounting standards)

Documents Profitability Financial Statement

Vouchers = Income – expenses = Balance Sheet
Ledgers Growth = Income Statement
Trial Balance Liquidity = Stmt of Changes in Equity
Report (Mgmt) Profitability = Cash Flow Statement
= Notes to the Accounts

STAKEHOLDERS
Copyright © IBFIM 2024. All Rights Reserved 9
THE COMPARISON BETWEEN
ISLAMIC AND CONVENTIONAL ACCOUNTING
Both Islamic and conventional accounting is about providing information, however, the
differences lies in the following:
❖ The objectives of providing the information
• buy, sell or hold on investment vs + adherence to certain Shariah principles and
rules and also try to achieve certain socio-economic objectives encouraged by
Islam
❖ What type of information is identified, and how it is measured and valued, recorded
and communicated
• economic events and transactions vs + socio-economic, religious events and
transactions
• interest (riba) vs profit determination
• historic cost (or lower) vs current valuation at least for zakat computation
❖ To whom it is communicated
• shareholders and creditors vs + society as a whole can make corporations
accountable for their actions, achieve equitable allocation and distribution of
wealth
Copyright © IBFIM 2024. All Rights Reserved 10
SET OF FINANCIAL STATEMENTS
FOR ISLAMIC BANKS
Basic Set of Financial
Statements for Islamic
Banks

Similar to
Unique to Islamic
conventional financial
Banks
statements

Statement of Financial Income Statement Statement of Changes Statement of Sources

Position (Balance (Profit and Loss in Restricted and Uses of Zakah
Sheet) Account) Investments and Charity Funds

Statement of Retained
Statement of Sources
Earnings (Statement
Cash Flow Statement and Uses of Qard
of Changes in Owner’s
Fund
Equity)
Copyright © IBFIM 2024. All Rights Reserved 11
GENERAL ACCOUNTING PRINCIPLES & POLICIES

Essential for Credit Officers:

Understand basis on statements are drawn up in order to
assess customer’s finance performance and position.

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GENERAL ACCOUNTING PRINCIPLES & POLICIES – cont.

Generally, 2 branches of accounting:

• Management Accounting
➢ Involves preparation of internal reports for management. decision
making purposes. E.g.:- Product costing and sales budget report
• Financial Accounting
➢ Involves maintaining accounting records and preparation of finance
reports for external parties.
• Governed by Companies Act 1965 and Malaysian Finance Reporting
Standards (MFRS)
• Issued as public documents at end of every financial year.

Copyright © IBFIM 2024. All Rights Reserved 13

GENERAL ACCOUNTING PRINCIPLES & POLICIES – cont.

• Accounting Practices & Doctrines

• Accounting Principles

• Accounting Policies

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GENERAL ACCOUNTING PRINCIPLES & POLICIES – cont.

Accounting Practices
• Rules are referred to as Accounting Doctrines and Principles.

Accounting Doctrines
• Concepts and ideas that are universal to the finance accounting process in business
organization.
• Provide logic and theory to treatment of business revenue and expense transactions in
determining profitability and reporting business financing condition and position.

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GENERAL ACCOUNTING PRINCIPLES & POLICIES – cont.

1. Consistency
• Accounting policies should be continuously and consistently observed and applied.
➢ E.g. Straight line depreciation method consistently adopted from year to year.
• Does not preclude changes if changes are desirable.

2. Conservatism
• Concept of caution or playing it safe
• Inherent in the practice of valuing assets at the lower end of cost or fair OMV.
➢ E.g.: Estimation of equipment depreciation, suitable provision for bad & doubtful debts,
valuation of unsold inventory

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GENERAL ACCOUNTING PRINCIPLES & POLICIES – cont.
3. Disclosure
• Companies Act 1965 requires all companies to disclose and report them in the published balance sheet
• Requires all accounting statements to be scrupulously honest and made available for public assessment
• Disclosure of finance Information – serves to provide external parties to understand results and make
appropriate finance and business decisions
➢ E.g.: Banks, creditors and investors

4. Materiality
• The management of the firm would have their own ways to consider what the main and essential
matters are and what are not to the operation of the business. What is material to one firm may not be
material significantly to another firm.
• These are two main areas of materiality that accounting is concerned with:
I. Materiality of information here refers to financial information. This aspect of materiality is about
potential repercussions on the assessment and decisions of the users of the financial information.
II. Materiality of amounts in the firm’s actual transactions that affect the firm. This will influence how
the amount should be treated in the accounts.

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GENERAL ACCOUNTING PRINCIPLES & POLICIES – cont.

Accounting Principles
• Rules and conventions adopted as general guide to companies in the treatment of
financial transactions
9 “Principles”:
1. The Entity Principle
Assumes business units is distinct from its owners
2. The Monetary Principle
Treat goods and services on a monetary basis and historical records are kept on
that basis
3. The Historical Cost Principle
• Cord of the transactions affecting an accounting entity.
• Financiers need to make interpretative judgements in analysing financial
statements

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GENERAL ACCOUNTING PRINCIPLES & POLICIES – cont.
9 Principles – cont.

4. The Continuity / Going Concern Principle

• Assumes that a firm would want to perpetuate its existence
• Earning power (not cost or liquidation price) is the significant basis for
valuing a continuing business venture and to justify its existence
5. The Accounting Period Principle
• Life of a firm can be divided into chapters known as accounting
periods
• Normal accounting period = 12 month duration
• Interim results can be prepared for shorter time period
• Interim reports important to financiers to manage credit effectively

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GENERAL ACCOUNTING PRINCIPLES & POLICIES – cont.

9 Principles – cont.

6. The Accounting Equation Principle

• Derivative of the historical record and monetary principles – actually a balancing tool
• Assets = Liabilities + Capital (Equity)
• Liabilities = Assets – Capital
• Capital = Assets – Liabilities
7. The Accrual / Matching Principle
• Income for a given accounting period is recognised as being earned or realised
➢ Revenue Expenditure: Relates, or is deemed to relate , to the current accounting period
➢ Capital Expenditure: Expenditure incurred which benefits current and future accounting
periods.

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GENERAL ACCOUNTING PRINCIPLES & POLICIES – cont.
9 Principles – cont.
8. The Realization Principle
• Considers the point in time at which revenue is being recognised by a business
• Relates to the time when goods / services delivered / rendered , as a result , the
customer pay cash or account payable
➢ E.g.: business engage in long term contracts, revenue recognized either on
completed basis or % of completion
9. The Double Entry / Dual Aspect Principle
• Relates to function of book keeping where every transaction has at least 2 aspects to
be recorded – uphold accounting equation.
➢ E.g.: If firm obtain financing from Bank, the assets, in the form of cash, will
increase the amount financed, while the liability, in the form of bank financings,
will also increase by the same amount.

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GENERAL ACCOUNTING PRINCIPLES & POLICIES – cont.
Accounting Policies
• Procedures adopted by firm in preparing and presenting financial
statements

3 Considerations:
1. Prudence (Discretion)
➢ E.g.: Prudence and policies relating to provisions for bad and doubtful
debts, depreciation of various types of assets
2. Substance over form
➢ E.g.: Hire Purchase / Leasing: Lessees should still account the assets in
their books because in substance they have exclusive use of them for
the entire life of the assets.
3. Materiality
➢ Refer to Malaysian Accounting Standard Board

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GENERAL ACCOUNTING PRINCIPLES & POLICIES – cont.

Example of Difficulties in Accounting may arise:

1. Valuation of unsold stocks at the end of the accounting period when
market prices either declined / increased
2. Determination of annual depreciation for fixed asset used / not in
use
3. Treatment of office renovation costs incurred: To decide whether to
be accounted for as Expense / Asset
4. Whether provision for bad and doubtful debts should be provided
and what suitable amount

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UNDERSTANDING FINANCIAL STATEMENTS
Components of Annual Reports
1. Balance Sheet / Statement of Financial Position
Equation: Assets = Liabilities + Capital
• Major limitation: Info historical and static
• Used to assess the following:
➢ Extent of shareholders’ finance commitment in the company
➢ Quick snapshot company’s short term solvency
➢ Appropriate of funding structure in relation to nature of business
2. Profit and Loss Statement / Statement of Comprehensive Income
• Report card on performance of management
• Reflection of how company is managing its business and resulting increase / decrease in
wealth to its shareholders
➢ Red: Marginal / Total failure
➢ Black: Distinction / Marginal pass
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UNDERSTANDING FINANCIAL STATEMENT – cont.

Components of Annual Reports

3. Cash Flow Statement
• Reveals the sources and applications of cash during the year
• Understanding to the size and sources of cash and how it can be used
• Credit officer: To understand that profitability is not equal to liquidity due to use
of accrual system where income and expenses recognized ahead of payments

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UNDERSTANDING FINANCIAL STATEMENT – cont.
Components of Annual Reports

4. Notes to Accounts
• Normally include:
➢ Significant accounting policies
i. Basis of accounting: historical, cash / accrual
ii. Depreciation policy: methods and rate
iii. Stock valuation method: LIFO or FIFO, fair value and subject
to impairment test
iv. Income recognition: Long term contracts - % of completion
or completed basis

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UNDERSTANDING FINANCIAL STATEMENT – cont.

Components of Annual Reports

4. Notes to Accounts – cont.

• Normally include :
➢ Breakdown of fixed assets by categories
Assist credit officers in assessing the following:
1. Whether customer has right combination of fixed assets
consistent with nature of business
2. Possibility of customer outsourcing some production processes-
reduce investment in fixed assets
3. Possibility of hidden reserves – Properties acquired long ago not
been re-valued

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UNDERSTANDING FINANCIAL STATEMENT – cont.

Components of Annual Reports

4. Notes to Accounts – cont.

• Normally include :
➢ Collateral arrangement for banking facilities & maturity profile of
term loans
Assist credit officers in assessing the following:
1. Their position vis-à-vis other financiers at least pari passu
(equal footing) and not worse off
2. Form a general opinion on bargaining position of company with
its financiers
3. Provide constructive notice whether the company has capacity to
encumber any of its assets - negative pledge

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UNDERSTANDING FINANCIAL STATEMENT – cont.
Components of Annual Reports – cont.
5. Subsequent Balance Sheet Significant Events
• Impact on future business direction, profitability and financial position
• Credit officers: need to find out company’s plan in expanding its capacity and how
purchased financed will affect gearing position
6. Capital Commitment
• Importance in relation to expansion of capacity and financing
7. Stock Breakdown in Broad Categories
• Credit officers: to check against modus operandi of business to ensure that is
consistent or warning sign
8. Investment in Subsidiaries and Associate Companies
• Credit officer to identify major operating subsidiary and associate companies and
assess company’s corporate strategy and synergy

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UNDERSTANDING FINANCIAL STATEMENT – cont.
Components of Annual Reports – cont.
9. Related Party Transactions
• 2 possible categories
➢ Trade-related transactions: represent purchases from or sales to related parties
➢ Advances: represent amount owing to or by related parties can be treated as form
of capital leakage
10. Contingent Liabilities
• Not liability yet on B/Sheet date but may become liability at some future date
➢ E.g.: Outstanding major public liability / litigation
• Credit officers need to assess such risks.
➢ 3rd Party guarantees relate to the co. guaranteeing on behalf of its subsidiary /
related cos.
➢ Major outstanding unrealized finance obligations such as LCs, FOREX Exchange
contracts, derivatives, etc.

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UNDERSTANDING FINANCIAL STATEMENT – cont.
Components of Annual Reports – cont.

11. Non-Financial Information

Chairman’s Report
• Only required for company listed on stock exchange
• Provide basis for credit officers to assess:
➢ Major events / activities which can impact future of company
➢ Risk / opportunities and they addressed them
➢ Future plans, risks and prospects of company
• Enable credit officers to take appropriate actions:
➢ Provide more credit lines to finance company expansion plans
➢ Remain at status quo and monitor closely
➢ Look out for opportunities to reduce credit exposure

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UNDERSTANDING FINANCIAL STATEMENT – cont.
Components of Annual Reports – cont.
11. Non-Financial Information
Directors’ Report
• Mandatory report required in Companies Act 1965
• Declaration by reporting directors what is reported is TRUE
• Credit Officer : Failure to read resulting in missing out critical info concerning customer
• Prescribed format should include:
➢ Names of directors and extent of shareholdings
➢ Acquisitions / Disposals
➢ Issuance of shares / debentures
➢ Provisions for Bad and Doubtful debts and diminution of value of assets
• Prescribed format should include:
➢ Appointment of Auditors
➢ An Attestation
➢ Extraordinary Items During or After Financial Year

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UNDERSTANDING FINANCIAL STATEMENT – cont.
Components of Annual Reports – cont.
12. Activities Report
• Not mandatory unless publicly listed
• Allows credit officers to be informed of company range of products or
activities
13. Auditors’ Report
• Every limited company required by Companies Act 1965 to have
annual accounts audited
➢ Appointment of Auditors
➢ An Attestation
➢ Extraordinary Items During or After Financial Year

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UNDERSTANDING FINANCIAL STATEMENT – cont.

Components of Annual Reports – cont.

13. Auditors’ Report
• Auditors’ opinions
❖ Disclaimer Opinion
❖ Unqualified Opinion
Because of limitations in scope of
Statements present fairly the finance position
audit/uncertainties about future that cannot be
and results of operations in conformity with
resolved/effect of which cannot be estimated, the
generally accepted accounting principles
auditors cannot express an opinion
❖ Qualified Opinion ❖ Adverse Opinion
Statements present fairly the finance position Statements do not present fairly financial
and results of operations in conformity with position/results of operations in conformity with
generally accepted accounting principles but generally accepted accounting principles.
auditors have some reservations *Rarely encountered.

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UNDERSTANDING FINANCIAL STATEMENT – cont.
Components of Annual Reports – cont.
14. Management Explanation
• Management will be given a chance to explain
• Auditors will still express unqualified opinion if management rectifies the
issues quickly
15. Reasons for Qualifying the Report
• Non-compliance with approved accounting standards
E.g. Non-consolidation of accounts with its subsidiaries
• Uncertainties surrounding the value of assets
E.g. Value of equipment / account receivables
• Going concern ability is in doubt
E.g. Negative net worth

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UNDERSTANDING FINANCIAL STATEMENT – cont.

Fundamentals of Balance Sheet

• Balance sheet classified into different categories:

ASSETS LIABILITIES
Non-current Assets Owner’s Equity
Intangible Assets Long-term Liabilities
Current Assets Current Liabilities

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FUNDAMENTALS OF BALANCE SHEET

Classification of Assets

1. Non-current assets
• Comprise permanent assets, no intention of selling within next 12 months
✓ E.g. Fleet of aircraft, plantation land, plant and machinery

2. Intangible assets
• Permanent in nature but not in physical form
✓ E.g. Licenses, copyrights and brands and expenditure capitalized for
periodic write offs

3. Current assets
• Converted to cash within the next 12 months

Copyright © IBFIM 2024. All Rights Reserved 37

FUNDAMENTALS OF BALANCE SHEET – cont.

Classification of Liabilities

1. Current liabilities
• Comprise obligations that need to be honoured within next 12 months
✓ E.g. Trade creditors, overdrafts, bills payable

2. Long term liabilities

• Comprise obligations that need not to be honoured within next 12
months
✓ E.g. Term financing, hire purchase

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FUNDAMENTALS OF BALANCE SHEET – cont.

Classification of Capital

Share capital
• Represents the capital funds put up by the shareholders into
business and represents permanent commitment
• 2 general class of shares, namely:
1. Ordinary share capital
• Absolute ownership as the shares come with voting rights
• No dividend assurance to shareholders
• Risk capital of the business

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FUNDAMENTALS OF BALANCE SHEET – cont.

Classification of Capital-cont.
2. Preference share capital
• Restricted ownership rights and do not come with voting
rights
• Some dividend income assurance but not a guaranteed
payment
• Dividends will have to be declared to them before any
dividend can be declared to ordinary shareholders
• Event of liquidation, voluntary/involuntary, preferred
shareholders will be paid their par value before ordinary
shareholders

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FUNDAMENTALS OF BALANCE SHEET – cont.

Classification of Reserves
• Funds belonging to the ordinary shareholders
• Need not be in the form of cash

2 types of reserves namely:

1. Revenue reserves
• Arise from business daily operations
• Some dividend income assurance but not a guaranteed
payment
• Represent accumulated profits generated by the company
over the years and not distributed to shareholders as
dividend/bonus shares

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FUNDAMENTALS OF BALANCE SHEET – cont.
Classification of Reserves – cont.
2. Capital reserves
• Arise from capital transactions and not profit and loss related
• Not available for distribution as cash dividend although can be distributed as
bonus share issue
• Total shareholders’ funds remains unchanged as only the composition has
changed
• No concern of capital leakage
• Arise due to asset revaluation exercise
• Does not cause any cash inflow
• Merely a book entry effect to reflect value of assets
• E.g.: share premium that arises as a result of share issuance at a price higher
than the par value
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FUNDAMENTALS OF PROFIT & LOSS STATEMENT

Classification of Revenues

2 main items namely:

1. Operating revenue
• Should relate to income generated from the core business
• Credit officers should circumspect in classifying income and
may need for reclassification in the financier’s spreadsheet
for analysis

2. Non-operating revenue
Income generated that is not part of the core business.

Copyright © IBFIM 2024. All Rights Reserved 43

FUNDAMENTALS OF BALANCE SHEET – cont.
Classification of Expenses
3 main items, mainly:
1. Cost of Goods Sold
Cost directly involved for the products sold and include manufacturing cost, shipping,
customs and port charges.

2. Operating expenses
• Relate to expenses that are incurred in the normal course of business
• Sub-categorized into 3 types:
❖ General and administrative expenses- salaries, rental of office, maintenance cost
❖ Selling and distribution expenses comprise salesmen’s salaries, commission,
advertising and promotion costs
❖ Finance expenses include profit on financing, bank charges and fees, bad debts
written off

Copyright © IBFIM 2024. All Rights Reserved 44

FUNDAMENTALS OF BALANCE SHEET – cont.

Classification of Expenses – cont.

3. Non-Operating expenses
• Refer to the expenses that the business has incurred but
which may not be related to its core activities
• E.g. Legal fees for acquisition of investment property, cost
incurred due to a major accident / natural disaster

Copyright © IBFIM 2024. All Rights Reserved 45

FUNDAMENTALS OF CASH FLOW STATEMENT
➢ Provide credit officers with an explanation of how cash was generated and applied.

Classification of activities in cash flow statement

Through 3 critical activities in any business:
1. Cash flow from operating activities
Examines the cash flow effects from the company’s day-to-day trading activities & its
efficiency in managing its daily Net Working Capital (NWC) for the year just ended
2. Cash flow from investing activities
Examines effects of the company’s strategic decisions (acquisition/disposal) concerning capital
expenditure, investment in subsidiary & associate company, research and development.
3. Cash flow from financing activities
Examines how a company sources its funds to finance any deficit that results from its operating
and investing activities

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FUNDAMENTALS OF CASH FLOW STATEMENT – cont.
The observations by credit officer to be made from the cash flow statement as
follows:
➢ Size of the cash flow from business profits (adjusting for provisions and
depreciation) as this represents the cash from its selling and production related
activities.
➢ Change in working capital items which indicates whether operating activities are
absorbing cash or releasing cash to the business.
➢ Size of investment activities especially purchase of assets, especially when
operating cash flow is not strong.
➢ Financing of any deficit cash flow including the repayment of financing & dividend
to shareholders. This observation is to be tied to the assessment of the ability to
make financing payments during the year i.e. debt service ratio.

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LIMITATIONS OF FINANCIAL STATEMENT

The limitations in the respective statements as follows:

➢ Limitation in the Balance Sheet
• Assets are recorded at historical costs.
• May not reflect the current market values.
• May not represent the economic reality.
• Static or snapshot of business – might be outdated by the time being analysed.

➢ Limitation in the Profit & Loss

• No indication as to whether future performance will improve/ deteriorate - Financier
depends on for finance payment in future.

➢ Limitation in the Cash Flow statements

• Does not reveal actual timing of balance sheet & Profit and Loss.
• Cash flow for entire year satisfactory although may be some hiccups.

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SHARIAH COMPLIANCE

Shariah Compliance

• Screening on Shariah permissible and non-permissible

activities.

• SAC of SC set benchmarks at 5% and 20% over Total Revenue

and Profit Before Tax, where excess is considered
unacceptable is suitable to apply on Investment activities.

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SHARIAH COMPLIANCE –
LIST OF SHARIAH NON-PERMISSIBLE ACTIVITIES

The 5% benchmark applies to the The 20% benchmark applies to the

following business activities following business activities
• Conventional banking • Hotel and resort operations
• Conventional insurance • Share trading
• Gambling • Stockbroking business
• Liquor & liquor-related activities • Rental received from Shariah non-
• Pork and pork-related activities compliant activities
• Non-halal food and beverages • Other activities deemed non-compliant
• Shariah non-compliant entertainment according to Shariah
• Interest income from conventional
accounts and instruments
• Tobacco and tobacco-related activities
• Other activities deemed non-compliant
according to Shariah

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QUANTITATIVE ANALYSIS

Framework for Analysis

Usually referred to:
1. Financial Analysis
2. Comparative Analysis
3. Comment and Judgment based on results, causes and
solutions.

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QUANTITATIVE ANALYSIS – cont.

Overview
Risk decisions must be based on the following:
1. Detailed analysis of the business past performance
2. The value of the business projected cash flow
3. Supporting collateral

Copyright © IBFIM 2024. All Rights Reserved 52

QUANTITATIVE ANALYSIS – cont.

Comparative Financial Statements Spreadsheets:

1. Balance Sheet
2. Income Statement
3. Cash Flow Statement
4. Ratio Analysis

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BALANCE SHEET

Balance Sheet (Financial Position)

Snap shot of a company’s financial positions at a particular
date. This represents what the company owned (assets)
and owed (liabilities). The residual between the assets and
liabilities is called equity.

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BALANCE SHEET – cont.

Examples: Examples:
• Property Plant • Inventory
NON- and Equipment • Trade
Receivables
CURRENT
CURRENT • Investment
• Goodwill • Other ASSETS
ASSETS Receivables
Examples:
• Deferred tax • Share Capital
assets • Investments
• Share Premium
• Patents • Cash and Cash
• Revenue Reserves EQUITIES
Equivalent.
• Foreign Exchange
Reserves
• Revaluation of
Examples:
Examples: Reserves
NON- • Long Term CURRENT
• Trade Payable
CURRENT Financing LIABILITIES
• Other Payable
LIABILITIES • Deferred
• Taxation
Taxation

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BALANCE SHEET – cont.

Balance Sheet Analysis:

a. Asset Consistency
b. Short Term Solvency
c. Long Term Financial Stability
➢ Level of gearing
➢ Over gearing
d. Funding Stability

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BALANCE SHEET ANALYSIS

Balance Sheet Analysis:

➢ Explain significant movement. AVOID elevator analysis

• YOY trend : Assets, Liabilities & Net worth.

➢ Compare against peers / industry.

Copyright © IBFIM 2024. All Rights Reserved 57

COMMON RED FLAGS

Balance Sheet Analysis: Common Red Flags

➢ Asset Q (Non FI): Relationship of Profit and Lost and Balance
Sheet
➢ Impact on future profit
✓ Obsolete stock: High stock turnover
✓ Collection problem: High debtors turnover
✓ Overtrading: sales growth vs debtors turnover
✓ Relationship issue with suppliers: low or declining trend of
creditors turnover

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COMMON RED FLAGS – cont.

Balance Sheet Analysis: Common Red Flags

➢ Asset Q (FI): Relationship of Profit & Lost and Balance Sheet
➢ Impact on future profit
✓ Profit Margin = Revenue / Receivables
✓ Funding cost = Total funding cost / financing
✓ Collection problem

➢ Due from related parties : Leakages of funds via intercompany transactions.

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COMMON RED FLAGS – cont.

Balance Sheet Analysis: Common Red Flags

➢ Liabilities
✓ Details of borrowings & impact on financing structure
✓ Details of legal suit & impact on company; character issue?
✓ Advances from related parties / directors & impact on financing
structure

➢ Net worth
✓Erosion of capital despite profit. History of losses;
What? When? How? Why?
✓Advances to related parties > Capital; Leakages?

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INCOME STATEMENT (EARNING CAPACITY) – cont.

Refer to:
a. Profit and Loss Statement.
b. Earning capacity of the business
c. Results of the company’s business activities.
d. Most important component in the annual report after
Balance Sheet.

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INCOME STATEMENT (EARNING CAPACITY) – cont.
Income Statement (Earning Capacity)
Item presented are:
a. Revenue
b. Cost of Good Sold
c. Gross Profit
d. Selling and Distribution cost
e. Administrative Expenses
f. Other Income
g. Profit from Deposits
h. Profit before Tax
i. Tax expenses
j. Net Profit

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INCOME STATEMENT ANALYSIS

Analysis should be focused on the following:

a. Quality of Earning
b. Future Profitability

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PROFIT & LOSS ANALYSIS

Methods of Analysis:

➢ Explain significant movement. Avoid elevator analysis

• YOY trend : Sales, Cost, Profit, Margin. What? Why? How?

➢ Compare against peers / industry. What? Why? How?

➢ Profitability indicates viability and NOT cash flow generating ability

➢ Must relate Profit and Loss analysis and Balance Sheet analysis

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CASH FLOW ANALYSIS

Cash Flow Analysis (Liquidity Position)

• Cash pays for debt servicing, not profit.
• Especially important in Project finance
• Direct method more useful for analysis
• Important to understand the concepts of:
o Cash Flow from Operations
o Cash Flow from Investing
o Cash Flow from Financing
o Free Cash Flow

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CASH FLOW ANALYSIS – cont.
Cash Flow from Operations
• Amount of cash generated by the Business from its daily operations

• Positive Net Cash Flow from Operating Activities :

Business able to generate enough cash from its Operating activities to take care of
its daily cash needs and meets its tax obligations.

• Negative Net Cash Flow from Operating Activities is acceptable provided that:
o Not for prolonged period
o Not huge relative to the size of business, otherwise may be a sign of
Overtrading
o Not caused by poor working capital management that has triggered the
widening of financial gap
o Main source of CASH > Tax and Financing obligations;
otherwise can be sign of over gearing

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CASH FLOW ANALYSIS – cont.
Cash Flow from Investing activities
Cash Flow implications on non-day to day strategic decisions:
➢ Capital Expenditure or Fixed asset:
▪ Negative Cash Flow
o Increasing its capacity in anticipation for future growth, or
o Replacing some major fixed asset
▪ Positive Cash Flow
o Business has not fully utilized its capacity; or
o Going through period of consolidation

➢ Investment in Business
▪ Negative Cash Flow: Embarking on acquisition trail
▪ Positive Cash Flow: Group rationalizing its activities, divesting interests that may
not fit into Group corporate strategy
▪ Company with consistently positive cash flow from investing is NOT growing

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CASH FLOW ANALYSIS – cont.

Cash Flow from Financing Activities

▪ Means of contributing, withdrawing and servicing funds to

support business activities (equity and debt)

▪ Positive when business has high negative cash flow from

investing activities – signifies that company needs to source
additional funds to finance the investing activities

▪ Negative (i.e. repayment of loans) if there is high positive cash

flow from operations and minimal investing activities.

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CASH FLOW ANALYSIS – cont.

Cash Flow from Financing Activities

▪ Details of sources of cash – provide understanding of business’s capital

structure
➢ Change in gearing level & its appropriateness i.e. increase in long
term assets funded by long term/short term source of cash
▪ If cash flow projections reveals that to meet obligations of maturing
debt
➢ Company shall undertake refinancing exercise/equity injection/sale
of assets
(important to asses options’ likelihood of success)

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FREE CASH FLOW

▪ Measure financial performance calculated as Operating Cash Flow minus

Capital Expenditures

▪ FCF represents Cash that company is able to generate after laying out
money required to maintain / expand its asset base – identify amount of
financing required and cash available for lenders and shareholders.
Cash flow from Operations
(+) Cash flow from Investing
= Free Cash flow

Copyright © IBFIM 2024. All Rights Reserved 70

RATIO ANALYSIS

Traditional form of financial analysis that goes beyond at

absolute numbers and considers relationship that exist within
various financial accounts, between the balance sheet and
income statement.

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FINANCIAL RATIOS
Types of Financial Ratios
1. Liquidity Ratios
Measure the ability of a company to meet its short term financial obligations
in a timely manner.
2. Debt-Service Ratio
Measure the ability of a company to service its debt obligation.
3. Gearing Ratios
Measure the solvency/financial commitment of the shareholders.
4. Efficiency Ratios
Measure the performance of operations such as the speed for conversion of
stocks to sales, etc.
5. Profitability Ratios
Measure the degree of profitability in relation to sales and investments.

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LIQUIDITY RATIO

LIQUIDITY RATIO FORMULA

CURRENT RATIO CURRENT ASSETS
CURRENT LIABILITIES

QUICK RATIO CURRENT ASSETS – STOCK

CURRENT LIABILITIES

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DEBT SERVICE RATIO

DEBT SERVICE RATIO FORMULA

INTEREST COVERAGE EARNING BEFORE INTEREST & TAX
FINANCE EXPENSE

INTEREST AND EARNING BEFORE INTEREST & TAX

PRINCIPAL PAYMENT INTEREST EXPENSE + PRINCIPLE
COVERAGE 1- Tax Rate

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GEARING RATIO

GEARING RATIO FORMULA

DEBT-EQUITY RATIO TOTAL LIABILITIES

TOTAL EQUITY

SHAREHOLDERS’ FIN. SHAREHOLDERS’ FINANCIAL

COMMITMENT-LONG COMMITMENT
TERM ASSETS RATIO LONG TERM ASSETS

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EFFICIENCY RATIO

EFFICIENCY RATIO FORMULA

DEBTORS TURNOVER AVERAGE TRADE DEBTORS X 365
(AVERAGE COLLECTION CREDIT SALES
PERIOD)
CREDITORS TURNOVER AVERAGE TRADE CREDITORSX365
(AVERAGE PAYMENT COGS
PERIOD)

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EFFICIENCY RATIO – cont.

EFFICIENCY RATIO FORMULA

INVENTORY TURNOVER
AVERAGE INVENTORIES X 365
(AVERAGE
COGS
STOCKHOLDING PERIOD)

NET SALES
ASSETS TURNOVER
AVERAGE TOTAL ASSETS

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PROFITABILITY RATIO

PROFITABILITY RATIO FORMULA

GROSS PROFT MARGIN GROSS PROFIT X 100
SALES
NET OPERATING PROFIT NET OPRTG PROFIT X 100
MARGIN SALES
RETURN ON ASSETS EBIT X 100
AVERAGE TOTAL ASSETS
RETURN ON EQUITY NPAT – PREF DIV X 100
AVERAGE ORDINARY
SHAREHOLDERS EQUITY

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WORKING CAPITAL FINANCING

➢ Purpose: To finance working capital requirements i.e. operations

➢ A credit limit will be made available to customer upon assessment of their
Working Capital Ratio (WCR)
➢ Short term financing with no fixed tenure and subject to periodic review
➢ Pricing is at Islamic variable rate i.e. against Base Financing Rate (BFR) or
Cost of Funds (COF) depending on types of facilities.
➢ Charges based on utilised amount
➢ Type of Working Capital Financing is Overdraft or Trade Financing or
Revolving Credit
➢ Utilization is either via cheques or via instruction to Banks. Account will be
debited for utilization and credited for payment made. Amount repaid may
be used again.

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WORKING CAPITAL FINANCING

Typical working capital cycle of a trading company

Purchase Pay suppliers Sell products Collect cash

products / raw on credit from
materials on customers
credit

Financing Gap = Net Working Capital

Owe Pay Collect

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WORKING CAPITAL FINANCING – cont.
Determination of Net Working Capital
Projected • Average stock holding period (in months) X stock cost as a %
Stocks of sales X average monthly sales

Add

Projected • Average debtors turnover (in months) X (100% - Cash profit

Debtors margin) X average monthly sales

Less

Projected • Average creditors turnover (in months) X purchase cost as a % of

Creditors sales X average monthly sales

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OUTCOMES VIA FINANCIAL INDICATORS

I. Buyer Power
• Extended credit terms may have to be given to maintain
Debtors market share.

Stock • Levels of finished goods may start to rise as sales fall away.

• Margins will come under pressure and potentially expenses

Profit increases.

• Volume sales may fall, levels of growth will also be affected.

Sales • New markets may be sought to counteract the situation.

Cash • will become tight as margins are eroded and good controls
Flow are necessary.

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OUTCOMES VIA FINANCIAL INDICATORS – cont.

II. Supplier Power

• Shorter credit may have to be given to counter suppliers’
Debtors powers.

Stock • Levels of finished goods may start to vary.

Creditors • Terms maybe shorter as suppliers exercise their strengths.

Profit • Margins will come under pressure.

Cash • will become tight as margins are eroded and good

Flow controls are necessary.

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OUTCOMES VIA FINANCIAL INDICATORS – cont.
III. Competition & New Entrants
• Extended credit terms may have to be given to
Debtors maintain market share.

• Levels of finished goods may start to rise as sales falls

Stock away.

• Terms may shorter as competitors seek suppliers in

Creditors lengthening in an effort to compensate for the
increase in credit given.

• Margins will come under pressure and potentially

Profit increase.

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OUTCOMES VIA FINANCIAL INDICATORS – cont.
III. Competition & New Entrants – cont.

• Volumes may fall; levels of growth will also be affected.

Sales • New markets may be sought to counteract the situation.

Term • In a competitive environment, replacement /repair may be

part off, or conversely survival may come from
Assets modernization .

Cash • Will become tight as margins are eroded and good controls
Flow are necessary.

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QUALITATIVE ANALYSIS
Shariah Compliance:
1. Production of goods and services which contradict the value
pattern of Islam (haram)

2. Economic activities involving gambling (maysir) and

uncertainty (gharar)

3. Financial transactions involving interest (riba)

4. Image, maslahah (benefit in general)

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ACCEPTED & PROHIBITED SECTORS
IN ISLAMIC FINANCE

Accepted Sectors Prohibited Sectors

• Infrastructure • Alcohol
• Utilities • Entertainment
• Manufacturing • Gambling
• Telecoms • Pork Products
• Retail • Tobacco
• Transportation • Conventional financial
• Islamic financial institutions institutions

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QUALITATIVE ANALYSIS

1. External Parameters:
a) Law of country
b) BNM

2. Internal Parameters:
a) Financing Policies
b) Financing Procedures

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EXTERNAL PARAMETERS – cont.

1. Economic and Political Factors

a) Inflation
b) Financing Rate
c) GDP, Tariff and Political Condition

2. Market Factors
a) Bargaining Power of Buyers & Suppliers
b) Can the product be substituted
c) Key players
d) Barriers to Entry
e) Product life Cycle
f) Competitive Strategy

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EXTERNAL PARAMETERS – cont.
1. Economic & Political Factors

• Financing Rates
➢The effect on the buyers as well as on the servicing of
profit payments in the Profit and Loss accounts.
Economic • Exchange Rates
• Inflation Rates
• Relationship between the industry and economic cycles
• Impact of price on demand & supply

• Government restrictions to entry

➢e.g. licenses
Political • Quotes/tariffs on products
• Duty/taxes
• Gross Domestic Product (GDP)

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EXTERNAL PARAMETERS – cont.
2. Market Factors
a) Bargaining Power of Buyers & Suppliers
b) Can the Product be Substituted
c) Key Players
d) Barriers to Entry
• The threats of competition entering the market is seen as indicator of
competitiveness of the industry.
• Examine the following key issues and assess the level of threat:
i. Capital Requirement

Plant & Research & Investor

Advertising
Machinery Development Returns

▪ The availability of capital is going to be an obvious barrier

▪ Return on investment gains importance - the greater the level of “external”
finance requirements.
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EXTERNAL PARAMETERS – cont.
ii. Economies of Scale

Large High Fixed

Production Costs are a Purchasing Marketing
Capacity barrier

Sales Service

▪ Any one of these, or combinations can create a Barriers to

Entry.
▪ Evaluation of the ability for new entrants to successfully
and cost effectively overcome and avoid any of the above,
possibly through new technology, needs to be assessed.
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EXTERNAL PARAMETERS – cont.

iii. Switching Costs

One Time Changing Employee

New Equipment
Charges Suppliers Training

▪ The greater the cost involved the greater the barrier to entry.

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EXTERNAL PARAMETERS – cont.

e) Product Life Cycle

• Life Cycle Characteristics – Evaluate the business’s main products and
estimate the positioning on the life cycle; assessing the actual actions
in the various risk areas to establish if a correct strategy is being
followed:
AREA DEVELOPMENT GROWTH MATURITY DECLINE
Promotion Create Concentrate on Advertising Low advertising
widespread brand gives repeat spend needed, as
awareness; find recognition; buying and product awareness
acceptance. find niche . keeps exists. Market
High advertising Advertising market leaders become
and marketing high, but share. aggressive.
costs. gives market
share.

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EXTERNAL PARAMETERS – cont.
e) Product Life Cycle – cont.

AREA DEVELOPMENT GROWTH MATURITY DECLINE

Product Lower quality Good product Improved Little product
& with limited performance. product quality differentiation
Production number of with costs being Reducing level
designs. reduced. Less of product
Develop the product lines.
standards. differentiation.
Price/ High prices & Fairly high Falling prices. Initially low
Margins/ margins Low prices. High Lower profits & prices &
Profitability profitability. profits. margins margins.
Reasonable Falling may
margins. rise in late
decline.

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EXTERNAL PARAMETERS – cont.
e) Product Life Cycle – cont.
AREA DEVELOPMENT GROWTH MATURITY DECLINE
Competition Few New entrants. Price Exits. Fewer
competitors Many competition. competitors.
competitors. Shake out.
Mergers .
Finance High net cash Finance Increasing cash Liquidate –not
outflow and needed for inflows. required
initial losses. rapid equipment.
expansion; still Leaders can
net cash harvest market
outflows but position
profits
available for
funding

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EXTERNAL PARAMETERS – cont.

e) Product Life Cycle – cont.

AREA DEVELOPMENT GROWTH MATURITY DECLINE
Personnel Staff and train Add personnel Reduce Reallocate
new in production, workforce personal
management plan for gradually;
overtime. improve
efficiency
Buyers or High-income Widening Mass market. Sophisticated
Demand purchaser. buyer group, Saturation. buying . Full
Patterns Buyers must be willing to Repeat buying. awareness of
convinced to accept uneven Brand loyalty. products,
make a quality. Quality qualities,
purchase. awareness. brands &
competitors.

EXTERNAL PARAMETERS – cont.
e) Product Life Cycle – cont.
AREA DEVELOPMENT GROWTH MATURITY DECLINE
Manufacturing Over capacity. Under Start of over Substantial over
& Short production capacity. capacity or capacity.
Distribution runs. High Skilled Move towards optimum capacity. Diminishing
labour . High mass Lower labour skills. distribution
production costs. production . Long run channels leading
Specialised Shortage of production. to specialised.
distribution distribution Distribution
channels. channels
Product rationalized.
shortages.
Research High, establishing Medium, Medium/Low Low, on existing
& products improving Maintaining products - high
Development quality. quality- on new products.
differentiation.

EXTERNAL PARAMETERS – cont.
e) Product Life Cycle – cont.
AREA DEVELOPMENT GROWTH MATURITY DECLINE
Foreign Some exports Large exports. Reducing exports. Very few
Trade Few imports Increasing exports. High
imports imports.
Overall Increase market Build quality Protect existing Cost control.
Strategy share. image and market share and
spend on develop cost
promotion. advantages.
Focus Market Consumer Production Financial
penetration loyalty efficiency. controls.
Replacement
product.
Risk High risk Risks can be Risk awareness Leaders
taken determined by protected the
market position rest threatened.

INTERNAL PARAMETERS

Internal Analysis:

a. Business Operation
b. Management
c. Source of Information
d. Using the information

Know Your Customer (KYC)

• Comply with Internal “KYC” policy.

• May use the first 3Cs - Character, Capacity & Capital.

• Important initial process to build lasting mutually beneficial

relationship.

INTERNAL PARAMETERS – cont.

Fact Analysis:

1. Credit Memorandum and/or AA

2. CCRIS
3. CTOS
4. Bankruptcy Search
5. Industry Report

INTERNAL PARAMETERS – cont.

A. Business Operations: Recognize where the business and its

management are on their life cycle

Area of focus:
I. Ownership
II. Background and Brief History
III. Age
IV. Financial Relationship
V. Location
VI. Production
VII. Facilities
VIII. Sources of Supply
IX. Distribution and Marketing Channel

INTERNAL PARAMETERS – cont.
I. Ownership
II. Background and Brief History
III. Age
▪ Length of time the business in existence is obviously going to
contribute to the level of risk involved.
▪ Examples:
➢Development Stage: Newly formed business has the pitfalls.
➢Maturity & Decline Stage:
✓Family-run business existence for decades go through problems
at change of generation.
✓Lose or do not have the drive to bring the business forward, or
✓Take too much out of the enterprise.

INTERNAL PARAMETERS – cont.

IV. Financial Relationship

V. Location
▪ Physical location may be historical & inappropriate for future
development or business needs to expand.
▪ Assess whether:
➢ Distribution network available to get product/service to
market and to obtain supplies
➢ Capable of doing so without changing location.
VI. Production
VII. Facilities

INTERNAL PARAMETERS – cont.
VIII. Sources of Supply
▪ Where the business obtains its supplies?
▪ Is this a critical factor in cost structure, if so what threats are these?
▪ Analysis of supply power
➢ What are the alternative sources of supply?
➢ Is there any risk from technology?
▪ Establish supply chain can reduce risk.

IX. Distribution & Marketing Channel

▪ Discuss and understand distribution or sales risk involved with the markets where
the business is involved.
▪ Any currency or country risk created by environment?
▪ Discuss the economic situation in the market being supplied, demand patterns for
the business products or services.

INTERNAL PARAMETERS – cont.

B. Management: One of the most important aspects in any

business is the ability of the people involved, from top to
bottom

Area of focus:
I. Ownership
II. Goal Orientation and Commitment
III. Organizational Structure
IV. Background and Compensation of Level of Managers
V. Market Reputation
VI. Access to Technology

INTERNAL PARAMETERS – cont.

I. Directors
Outside
Background Track Record Combination
Interest

Other
business

NOTE *
▪ Commitment of directors e.g. politically influence can be detrimental
to the source of business.

INTERNAL PARAMETERS – cont.

II. Management

Qualifications Experience Track Record Functions

❖ Management
▪ Ensure appropriate organization and control
▪ Ensure strategy is continually developed and executed.
❖ Important to recognise
▪ How the management structure works?
▪ How decisions are made?
▪ Who the decisions makers?
❖ Examine style of leadership

INTERNAL PARAMETERS – cont.

III. Leadership

• Conceptual and directive style

Entrepreneurial • Risk Taker

• Analytical and directive style

Executive • Calculated risks

• Analytical and directive styles

Planner • But take few risks

• Conceptual, analytical and directive styles

Leader • Take high risk or be Risk Averse
• All or Nothing

INTERNAL PARAMETERS – cont.
IV. Labour Force

Ability to
Quality & Skills Required
provide
: Backbone of standards must
product/service
any business be assessed
on time

V. Sales Force
▪ Evaluate ability of business to market and sell its products.

INTERNAL PARAMETERS – cont.

C. Sources of Information:
a. Sources within the company:
a) Site Visits
b) Owner or Workers

b. Other sources:
a) Trade reference
b) Competitors
c) Other Financial Institutions
d) Internet
e) Market Talk

INTERNAL PARAMETERS – cont.

Using the Information:

a. Standard Reporting Format.
b. Policies and Procedures
c. Call Report
d. Financing Request Memo
e. Basic Information Report

QUANTITATIVE ANALYSIS EXERCISES

EXERCISE : 1 - RATIO ANALYSIS