In a recent interview granted by the president of the BBVA group, Francisco González, to the América Economía Magazine, he mentioned as an anecdote, the criticism that he had to endure, on the part of some sectors, for his overly conservative leadership of the bank, a position now admired by all, due to healthy growth, ample liquidity, high solvency, reduced delinquency, recurrence in results, control of spending and efficiency, high profitability and, above all, the non-contagion of toxic products achieved by its represented, which allows it to date wielding an enviable position in the midst of a global crisis, which the market has recognized, allowing it to scale and place BBVA among the 10 largest in the world, in terms of market value.
This feat was due to the fact of knowing how to interpret the warning signs in time, such as “the growing disconnection between the real economy that grew at 4% or 6% globally and the financial economy, which grew at incredible rates of 100% or 200%; that it could not continue like this, so, among many things, it decided that the BBVA group should not engage in excessively leveraged operations ".
But, the most important of his revealing comments comes here: “I was not the only one who thought so. Many others thought so, but they did not act accordingly and spread a little more because their regulation allowed them to do so ”.
And as if to end with a flourish, he mentioned something that we see every day, those of us who work in banking, that "when all competitors take a risk that you do not want to take, in the end it is very difficult to isolate themselves 100%", even worse when You have an ROE and ROA goal to meet, a placement and product goal to achieve. If the trend points in the same direction, the easiest thing is to follow the broad path of loosening the forecasts; avoiding the narrow path of foresight and caution, leaving aside what in the long run is the best path, as demonstrated by BBVA.
Precisely this article tries to avoid that, giving some healthy advice to consider when analyzing the financial statements for making financing decisions.
For a better analysis we have considered the two types of traditional financing; for working capital and fixed assets.
I. Financing of working capital
Working capital financing needs arise mainly from three factors:
- By negative operating cycle By campaign For extraordinary reasons. Permanent working capital
1. Negative operating cycle
Negative operating cycle occurs when average pay days cannot fund average cash and inventory days:
Duty Cycle = DPP - DPC - DPI
Yes: DPP <DPC + DPI, Duty Cycle is Negative
- DPP: Average days of payment CPD: Average days of collection DPI: Average days of inventory
In the event that its own financing is not sufficient, that is, the equity derived from both the contributions of the partners and the accumulated profits, the company normally resorts to banks to request loans for working capital. The first red flag to consider would be when the company tries to replace its own financing with loans from banks, that is, when it begins to divert resources that were normally in the business. If it is a fixed asset or a new business activity, we should be aware of the decision to make, to assess its potential effect on your current activity.
At this point it is also important to compare the credit and inventory policies of the company, with those that actually occur in practice (calculation of DPC and IPR), in order to know if they are really applied or not. For example, if the company grants 30-day credit, but its average collection days show 45 days, it is a sign of relaxation of the company and of possible subsequent liquidity problems. If DPP> DPC + DPI there is no need to grant working capital financing.
2. By Campaign
Normally, some companies have peak sales seasons, which coincide with certain dates, such as Christmas, Mother's Day; or months, such as, the school campaign. On such occasions, companies often apply to banks for working capital loans.
The problem arises when the payment period granted exceeds the maximum necessary, which causes the company to divert funds to other activities.
For example, if the loan requested is for a school campaign, the term should not exceed the month of April (classes start in March).
The analyst must take special care in the maximum term to be granted.
3. For Extraordinary reasons
On some occasions the company is forced by competition in the market, exceptionally to accept payment with invoices or letters. Such a situation generates illiquidity for future operations.
If the letter or a factoring operation cannot be discounted, the financing of such operations must coincide with the payment term of such documents.
On other occasions, the company may agree to purchase exceptional merchandise at highly competitive prices, for which it resorts to the bank to finance such purchases.
The financing term for the purchase of such merchandise must coincide with the average days of inventory or sale and collection of said merchandise. Granting a longer term could imply the diversion of money to other activities and make collection difficult.
4. Permanent working capital
When the negative operating cycle is permanent, that is, when the collection, inventory and supplier policies are constant, it is necessary to grant a medium-term credit line, so as not to decapitalize the business.
For example, when the credit policy of my suppliers is 30 days, my collection policy is 30 days and my inventories remain on average 30 days, there is a permanent negative operating cycle of 30 days, As long as such policies remain unchanged, always there will be a negative 30-day operating cycle, so it becomes permanent.
II. Fixed asset financing
For the granting of fixed asset financing we must consider two tools: EBITDA and free cash flow or freely available cash flow.
EBITDA
EBITDA = Operating Profits + Depreciation - Taxes
It allows to know if the business generates sufficient profits for the current payment of its current obligations and the credit commitments it intends to assume.
In this way we could calculate the EBITDA of their stations. historical and projected and verify if these allow you to cover your current current obligations and the current part of the proposed debt.
Free cash flow
In the event that the company had significant capital expenditures, free cash flow should be used instead of EBITDA, which is broadly EBITDA less capital expenditures (acquisitions of long-lived assets such as machinery, equipment and other assets that appear on the balance sheet instead of appearing in the income statement).
An analysis of this nature would allow us to calculate the real payment capacity of the company.
Another way to calculate the current payment capacity of the company and, incidentally, evaluate if we could give it more financing, is the following:
FCN = UO + D - I - A - T
OU: Operating profit
D: Depreciation
I: Annual interest on debt for Fixed Assets
A: Annual amortization of debt for Fixed Assets
T: Taxes
But the most important thing is that in addition to allowing us to evaluate the company's payment capacity, if we relate it to the debt / total sales ratio, it allows us to know the liquidity of the business.
Example:
Total Debt: $.8 million
Total Sales: $.5 million
Total Debt / Sales: 1.6 times
% sales
UO + D: 30% 30.0%
I (annual average): 10% x 1.6 - 16.0%
A: 25% x 1.6 - 40.0%
FCN: - 26.0%
In the present case, the company loses cash by 26% of sales per year, which gives us an idea of the difficulty it is going through and, incidentally, makes it not subject to credit.
Adjustments to Operating Income
Before completing the analysis, as we know that income is recorded independently of payments, therefore having nothing to do with its collection, the profits of the company are not necessarily money that the company receives. Because it is necessary to complement the EBITDA analysis with a tool that allows us to determine the cash income that the business actually generates to pay its obligations.
An alternative that could be used would be the following ratio (prepared by the author):
EBITDA = Adjusted Operating Income + Depreciation - Taxes
Adjusted Operating Income = UO (1 - DPC / 360)
where:
- UO = Operating Profit D. PC = Average collection days
This new empirical ratio would allow us to consider only spot sales for the calculation of Operating Profits, to be replaced in the EBITDA formula, which would bring us closer to the client's actual payment capacity.
Conclusions
In the current climate, rather than restricting access to credit, banks should focus their attention on assessing credit applications more thoroughly, using the most appropriate tools and putting into practice an old advice: never accept balance sheets as they are. present them.
