Finance Company Financial Statement Analysis & Ratio Analysis

Finance companies primarily borrow money in the wholesale markets and lend to, finances or leases assets or asset purchases to/by customers (creating receivables) and/or purchasing financial receivables originated by others. These receivables can either be held on balance sheet (with the company earning the interest spread between what the receivables pay and what the company pays on borrowed funds. The company can also securitize the receivables, receiving a one-time payment at par or discounted from the face value of the receivables (with some recourse provision) and continue servicing the portfolio for the investor (earning a management fee).

Finance companies can be described by their business line as specialty, diversified or consumer. The types of business lines that finance companies get involved in include vendor finance, equipment leasing, installment sales, import and export financing, structured finance, auto leasing, loans (working capital, term, revolving), asset management, rentals, remarketing, factoring and comsumer loans.

Is the company a captive (financing subsidiary of a manufacturing company)? These companies tend to be driven by the level of sales of parent sourced equipment.

The balance sheet size of a finance company is also important in considering the finance company but there are small, highly specialized finance companies that are quite profitable.

Assets

Current Assets

Cash: end of period cash; due from banks; as cash on hand earns the lowest return we are just looking to make sure it approximates a percentage of current liabilities.

Marketable securities: short-term investment of excess cash timed to be available with maturing liabilities.

Loan Receivables (net of Allowance for Loan and Lease Losses / ALLL)

The assets in this category will reflect what the company really is focused on: loans to consumers such as mortgages or home equity loans, credit cards, automobile financing, student loans, etc.; or if the focus is more on commercial customers then it may have commercial mortgages, equipment financing or leasing, etc.

The company may indicate Receivables as "Owned" or "Managed / Off-balance sheet". Owned, on-blance sheet receivables are loans owned by the company and they assume the full credit risk for the performance of the receivable

Managed is the the performance of both on-balance sheet loans and off-balance sheet loans owned by ecuritization trusts as a single portfolio

Retained Interest in securitizations includes the Residual Interest plus reserve and other cash accounts that serve as credit enhancements to asset-backed securities issued in the company's securitizations. Retained interests from securitization activities do not trade in an active, open market with readily observable prices thus the fair value is estimated using discounted cash flow models.

Goodwill and intangible assets, net (required to be tested for impairment on at lease an annual basis)

Other Assets

 

Liabilities

Current Liabilities

Deposits (through a banking subsidiary)

Credit balances of factoring clients

Commercial Paper

Short-term borrowings

Loans from affiliates

 

Long-term Liabilities

Medium-term notes

Long-term debt

Affiliate debt

Other Liabilities

Stockholder's Equity

Preferred Equity issue

Retained Earnings

Common Equity

Asset Quality

Asset Quality evaluates risk (and there must be some risk to earn a return), controllability, adequacy of loan loss reserves, and acceptable earnings; and the affect of off-balance sheet earnings and loss. The quality of a finance company's assets hinges on their ability to be collected a during and at maturity. Thus, one must examine the portfolio quality, diversification, the portfolio classification system (aging schedule and the methodology to classifying a receivable) and the fixed assets (the productivity of the long-term assets, for instance the branch network). It is also necessary to determine the liquidity and the maturity structure of various Assets. Investing in assets is how a finance company primarily earns a return. How well are these assets going to perform?

Good asset quality means that there is borad diversification both geograpically and across various borrowers / industries. In addition, not only should loans be secured as opposed to unsecured bu the underlying security / collateral is also very important.

Are the assets, as collateral to the receivables (if secured):

easily movable

have good residual value as the economic life exceeds the term of financing

applicable/utilization across a variety of different industries thus have a broad resale market

subject to rapid technological obsolescence

Does the company utilize credit scoring methodology or is creditworthiness decided on a case-by-case basis by credit personnel and management?

Does the company service and collect its own receivables or is there a third party?

It is important to understand the company's methodology for setting reserves as a percentage of non-performing receivables (60 days or longer overdue) and net charge-offs. Every product category receivable has a different inherent loss characteristic. Specific portfolio issues are:

growth of the number of receivables

product mix

bankruptcy trends

geographic concentration

economic conditions

portfolio seasoning

current level of charge-offs and delinquencies

Consumer Delinquencies (60 Days) / Total Receivables

Straight-forward ratio indicating how much of consumer receivables as a precentage of total receivables have paid late for the period.

Commercial Delinquencies (60 Days) / Total Receivables

Straight-forward ratio indicating how much of commercial receivables as a precentage of total receivables have paid late for the period.

Reserve for Losses / Net Charge-Offs

Indicates how much of a cushion a finance company has thus if the ratio is declining then the finance company may not be adding sufficient reserves in the event that charge-offs increase substantially. If the company waits to increase reserves at the last moment then profitability may be affected by a large provision against earnings.

Net Charge-Offs / Average Receivables

Provides an indication of how the portfolio is performing. An increase in this ratio will signify deterioration in the general economy, a specific industry or that underwriting standards need to be examined and improved.

Recoveries / Gross Charge-offs

Indicates how well residual value estimates were formulated and how well residual sales activity are going. An increase in this ratio can also indicate that general economic / business conditions are improving.

Leverage

Leverage is a measure as to what extent are the company's assets are financed with debt. By the nature of its business, finance companies are usually more leveraged than a manufacturing or service industry company.

Total Debt / Total Shareholder's Equity

Rather than a percentage this is usually presented as a ratio and it is not uncommon for the ratio to range from 4 to 1 (4X) to 10 to 1 (10X; or debt is ten times as large as equity). The sustainability of a higher level of debt in relation to equity is dependent upon the quality of the asset portfolio and whether there is any support from a parent company. Sometimes Loss Reserves are added to Total Shareholder's Equity.

Short-term Debt / Total Senior Debt

This ratio indicates how much of total debt may come due within one year or by the end of the year.

Funding & Liquidity

Funding and Liquidity are related, however they are separate situations. Funding is what a finance company relies upon to grow its business (originate new loans and leases) and the asset side of the balance sheet above and beyond what could be accomplished with just equity. Funding is provided by deposits (companies with bank subsidiaries), short-term debt and longer-term debt. Funding means access to capital.

Liquidity is what a finance company requires if Funding is interrupted and the finance company must still be able to meet certain obligations (finance company's ability to repay creditors without incurring excessive costs). What is the liability structure / composition of the company's liabilities, including their tenor, interest rate, payment terms, sensitivity to changes in the macroeconomic environment, types of guarantees required on credit facilities, sources of credit available to the company and the extent of resource diversification? Illiquidity can lead to the failure and bankruptcy of a finance company due to the high level of leverage and the constant requirement to refinance maturing funding sources.

Funding sources also include:

Net earnings

Issuance of common and preferred securities

Trust preferred securities

Commercial paper

Senior debt

Subordinated debt

Securitizing various financial assets including credit card receivables and other receivables generally secured by collateral such as single-family residences and automobiles

Monetizing investment securities

Liquidity refers to reserves of cash, securities, a finance company's ability to convert an asset into cash, and unused bank lines of credit. The faster the conversion the more liquid the asset. Illiquidity is a risk in that a finance company may not be able to convert the asset to cash when most needed. Moreover, having to wait for the sale of an asset can pose an additional risk if the price of the asset decreases while waiting to liquidate. Thus, if loans or assets are illiquid then liquidity is also limited, especially if the loans exceed stable deposits and available lines of credit. Liquidity must be sufficient to meet all maturing unsecured debt obligations due within a one-year time horizon without incremental access to the unsecured markets.

In a changing interest rate environment, is the company asset sensitive or liability sensitive. For instance, if interest rate rates are declining, and the company is liability sensitive, that means that borrowed funds mature or reprice at a faster rate than finance receivables, thus it can maintain a positive interest spread.

Earnings (Profitability)

Net Interest Income (annualized) / Average Interest Earning Assets

Net operating income (annualized) after taxes (including realized gain or loss on investment securities) / Total Average Assets (assets at the previous fiscal year plus assets at this current fiscal year divided by 2) for a given fiscal year

Earnings Before Interest & Taxes / Interest Expense

This is an examination of a company's ability to pay interest only (no principal). It is also known as a debt service ratio or the times interest earned ratio. The purpose of the ratio is to determine the company's ability to service the interest expense (being paid on its outstanding debt) out of funds generated by company operations. Earnings are the primary source for interest payment.

 

EBIT = Earnings Before Interest and Taxes (also before restructuring charges, extraordinary income or expenses, and dividends). The reason why we isolate income at this level is so that interest is not being paid by asset sales or one-time generated income. We do not utilize net income because both interest expense and the tax effect are deducted to derive the net income thus we add them back first to determine how much cash is available, before these expenses, to actually cover them.

 

You may not always be able to determine EBIT. Sometimes a finance company may go ahead and already deduct the interest expense from the gross income earned on its financial receivables, and then report net finance income along with its other sources of income and then report a "Total Revenue" figure. Thus, you will need to isolate interest expense.

 

Example:

$254,000 (Earnings before interest and taxes)

$89,500 (Interest Expense)

= 2.83x or 283%

 

What the ratio is saying is that for every dollar of interest expense there is 2.83 dollars of available cash to pay the expense. It also indicates the extent to which operating income can decline before the company's earnings are less than its annual interest costs. The higher the ratio the stronger the operations/cash flow is and indicates that the company has additional funds if it is under stress or wants to fund asset growth/acquisitions. If the ratio is low, than the company would have problems if it borrowed additional funds.

We want to show what the trend is for the company for, say, three years and what is happening in the most recent quarter.

Has the ratio weakened because cash flow is being reduced through higher S,G&A/Operating costs?

Is its debt floating rate and it is paying higher costs?

Are its receivables also paying floating rate and income will catch up with a pending reset of rates on its receivables?

Is there competition within the financial company industry that is putting pressure on what these companies charge their customers, hence lower interest income, but debt costs are stable?

Did the company take on more debt, hence higher expenses, however, the assets purchased with the debt funding are not throwing off improved income or they have not completely invested the borrowed funds?

Was there a securitization that reduced financial receivable income without a significant corresponding reduction of debt?

Has there been as serious deterioration in the quality of the assets (non-performing) that has reduced income while the debt level has not been reduced?

Are other sources of income to the company declining even though its receivables are performing well?

Management Structure

It is very difficult to measure the ability of the management of a finance company. Overall, one is looking for very well experienced industry professionals.