Adjustments to Financial Statement Made by the Credit Analyst

Especially if a customer or applicant's financial statement is not audited, and even if it is, you may find that some of the items strike you as being untrue or at least questionable.  If so, you can adjust the financial data for the purposes of your own analysis. The adjustments credit professionals typically make are:

1. Reclassifications. You can reclassify any item. For example, you might shift illiquid investments or loans to officers from "current assets" to "other assets" or even list them as non-current assets.   Conversely, you may want to reclassify debts from "long-term liabilities" to "current liabilities " if the customer is in default on its bank debt or is out of covenant on a loan. Reclassifications typically affect the customer's current ratio and quick ratio but more sophisticated reclassifications might also affect the debt to equity ratio or other common ratios. 

2. Reductions. You may also want to reduce or discount certain items. As mentioned previously, some creditors routinely exclude goodwill and other intangible assets from their analysis of a customer's balance sheet. You have the option to reduce any asset items that seem inflated, or to eliminate intangible assets except in cases where special circumstances warrant such value (such as an exclusive patent on a highly profitable product). 

When reviewing the balance sheet for items that should be reduced, pay particular attention to the accounts receivable and inventory figures. Suppose that you are suspicious of both of these items and have determined that the debtor company's average collection period is considerably longer than its terms of sale, indicating that a substantial portion of its receivables is well past due. You have found that its inventory turnover ratio is unusually low, indicating either that it is overvalued or that it includes obsolete inventory. 

If you decide to reduce the value of certain items, make a record both of the original figures and the adjusted ones. The most convenient way of doing this is to use a comparative financial statement sheet. In the first column, list the original amounts and in the second column, the adjusted amounts.

When you decide to reduce or write down the value of an asset such as inventory, you reduce the asset along with the value of total assets.  This has the effect of reducing the company's net worth. One of the goals of adjustment is to provide a more accurate picture of the customer's financial health.  

© 2010 by Michael C. Dennis.  All Rights Reserved