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Financial analysis: the ratios to calculate before going to the bank

How to reclassify the financial statements and calculate PFN/EBITDA, DSCR, cash conversion cycle and ROI before seeking financing, with a numerical example.

When a bank receives a set of financial statements, it first wants to know three things: how heavily net financial debt weighs on the margin the business generates (PFN/EBITDA, where PFN, posizione finanziaria netta, is the net financial position), whether cash over the next twelve months will be enough to pay loan instalments and interest (DSCR), and whether working capital is eating into liquidity. These figures are calculated from the reclassified financial statements, and it pays to work them out before walking into the branch.

The framework

No statutory provision prescribes a formula, but the law requires those who manage a business to monitor the financial balance that these ratios measure. Article 2086, second paragraph, of the Italian Civil Code (codice civile, c.c.) requires entrepreneurs operating in corporate or collective form to put in place adequate organisational, administrative and accounting arrangements (assetti organizzativi, amministrativi e contabili), also with a view to detecting a crisis in good time. Article 3, paragraph 3, of the Business Crisis and Insolvency Code (Codice della crisi d’impresa e dell’insolvenza, CCII: Legislative Decree no. 14 of 12 January 2019) specifies that those arrangements must bring to light any balance-sheet or economic and financial imbalances and verify that debts are sustainable for at least the following twelve months. Paragraph 4 lists the warning signs, including exposures to banks that are more than sixty days past due, or that have exceeded the credit limit for at least sixty days, where in aggregate they amount to at least 5 per cent of total exposures. Article 2, paragraph 1, letter a), defines crisis as the state that makes insolvency likely and that manifests itself in the inadequacy of prospective cash flows to meet obligations over the following twelve months. The DSCR answers part of this question, the part concerning financial debt: for the other obligations (employees, suppliers, the tax authorities, public bodies) a cash budget is needed.

Cash flows for the financial year just ended are shown in the cash flow statement (rendiconto finanziario; Article 2425-ter c.c., Italian accounting standard OIC 10), from which companies preparing abridged financial statements (bilancio in forma abbreviata) are exempt (Article 2435-bis, second paragraph, c.c.): in that case the bank reconstructs them using its own criteria. Banks follow the EBA Guidelines on loan origination and monitoring (EBA/GL/2020/06 of 29 May 2020, applicable from 30 June 2021). In Annex 3 the Guidelines list for businesses, among other metrics, EBITDA, the ratio of interest-bearing debt to EBITDA and debt service coverage; paragraph 267 refers to the same ratios for covenant monitoring. No statutory provision sets the thresholds: each bank applies its own, often differing by sector.

What it means in concrete terms

The starting point is to reclassify the balance sheet on a functional basis: on one side, invested capital, that is, fixed assets plus net operating working capital less the employee severance indemnity (TFR, trattamento di fine rapporto); on the other, sources of funding, that is, equity and PFN (financial debt less cash). Net operating working capital is inventory plus trade receivables less trade payables. EBITDA is not a line item in the format laid down by Article 2425 c.c.; here we calculate it as the difference between the value of production and the costs of production (A minus B), adding back depreciation, amortisation and write-downs (B10) and provisions (B12 and B13).

Take a fictitious srl (società a responsabilità limitata, an Italian limited liability company), with amounts in thousands of euro. Year 1: revenue 2,000, variable costs at 70 per cent, cash fixed costs 400, hence EBITDA 200; depreciation and amortisation 80, operating profit 120, finance costs 40, taxes 20 (notional rate of 25 per cent, for the purposes of the example only), net profit 60. In the balance sheet: fixed assets 900, inventory 300, trade receivables 400, trade payables 250, TFR 50; invested capital 1,300, funded by equity of 500 and PFN of 800 (term loan 500, of which 100 repayable within the year, short-term credit lines 350, cash 50). In year 2 revenue falls by 10 per cent, customers pay at 90 days, inventory stays unchanged and trade payables fall in line with purchases.

Data and ratios	Year 1	Year 2
Revenue	2,000	1,800
EBITDA	200	140
Net operating working capital	450	519
Cash conversion cycle (working capital in days of revenue)	82	105
PFN/EBITDA	4.0	5.7
PFN/equity	1.6	1.6
ROI (operating profit/invested capital)	9.2%	4.5%
Cost of debt (finance costs/PFN)	5.0%	5.0%
DSCR	1.07	0.26

Here the DSCR is available cash flow (EBITDA less taxes, less maintenance capital expenditure of 30, less the increase in working capital) divided by debt service, i.e. principal of 100 plus interest of 40. Year 1, with working capital unchanged: 200 − 20 − 30 = 150, and 150/140 = 1.07. Year 2: working capital absorbs 69 (trade receivables 444, inventory 300, trade payables 225), taxes fall to 5 and cash flow becomes 140 − 5 − 30 − 69 = 36, and 36/140 = 0.26. PFN rises to 804, because the cash flow of 36 is not enough to pay the 40 of interest. ROI, 60 on invested capital of 1,319, falls below the cost of debt: every euro borrowed now costs more than it earns.

The income statement still closes with a profit of 15, while cash flow covers barely a quarter of instalments and interest. It is this gap between profit and cash that the bank looks at, and that abridged financial statements without a cash flow statement do not reveal on their own.

In practice

• The directors (organo amministrativo) prepare the reclassification and calculate the ratios for every set of annual financial statements, before submitting them to the shareholders (for an srl, within one hundred and twenty days of the year end, unless the longer period allowed applies, Article 2478-bis c.c.).
• At least every six months, on the basis of up-to-date interim accounts, the twelve-month DSCR is recalculated starting from a cash budget.
• Before applying for financing, a file is prepared containing the financial statements and their reclassification, the cash flow statement (even where not mandatory), the twelve-month budget, the debt repayment schedules and the latest data from the Centrale dei rischi (the Bank of Italy’s Central Credit Register).
• Before the financial year ends, while there is still time to act, the covenants (the limits on ratios set in the loan agreement) are checked using the definition written into the agreement.
• The minutes in which the directors review the ratios are kept on file: they help show that the arrangements required by Article 2086 c.c. exist and work.

Mistakes to avoid

• Reading profit as if it were cash: in the example a profit coexists with a DSCR of 0.26.
• Calculating PFN while leaving out advances on invoices, leases or shareholder loans: the bank treats them according to its own rules, and it is better to know those rules in advance.
• Stopping at the year just closed: both the law and the bank look at the following twelve months.
• Letting credit-limit overruns reach sixty days: if in aggregate they amount to at least 5 per cent of bank exposures, they are a warning sign under Article 3, paragraph 4, CCII. The bank concerned sees them immediately and, above the reporting threshold, other financial intermediaries also find them in the Centrale dei rischi.

References

Articles 2086, second paragraph, 2425, 2425-ter, 2435-bis, second paragraph, and 2478-bis c.c.

Legislative Decree no. 14 of 12 January 2019, Articles 2, paragraph 1, letter a), and 3, paragraphs 3 and 4

accounting standard OIC 10 “Rendiconto finanziario” (cash flow statement)

EBA Guidelines on loan origination and monitoring, EBA/GL/2020/06 of 29 May 2020, paragraph 267 and Annex 3