Once we have fully grasped a company’s operating environment and competitive position, only then we start with a financial risks analysis. This part of the analysis starts with the analysis of historic financial statements. The question is, how far back into the past should we look? While there are no clear rules, there are certainly some good practical tips.
The ideal option
The ideal option is to look ten years into the past. Yes, you’ve read it correctly – ten (10). However, this is an ideal solution, which may not be needed in most of the cases. Financial / credit analyses are almost never performed in ideal conditions, therefore this guidance is probably not viable in most of the cases. Still, even though the number crunching part of the analysis is painful and sometimes boring, it is absolutely necessary to put everything we know about the company into context. The ideal option of ten historic years is extremely helpful when analysing cyclical companies, which may have gone through one or two crises or may have had larger investment programmes. Having ten years would allow us to understand how the company did during downturns, what were the management’s strategic moves and applied financial policies. It is also much easier to spot trends from a longer series of data.
The more practical option
The more practical option is to analyse five years of historic financial statements. This is also a general approach of CreditAnalyst.eu (CAeu) when analysing financial statements. Five historic years normally allow to spot trends and analyse most recent performance. Some strategic decisions like acquisitions or large expansions into new markets or products take at least two years to yield full results. Hence, five years should be enough in most of the cases, however, for more cyclical companies one could extend it to seven or eight years in order to capture the full cycle.
The no-go option – real example
Unfortunately, many banks and financial institutions show only three years of historical financial statements in their credit proposals. This may not provide sufficient depth to understand how the company did in the past and how did the management’s strategies impact the company’s performance. Especially for cyclical companies this is a clear no-go. Whatever happened during the last three years, it is likely not a true representation of where the company is heading.
Here is one practical example from the recent analysis for one of our clients. CAeu analysed a company in the capital goods industry. We applied the practical option of analysing five historic years into full detail, with three additional years to assess the capacity of the company to generate sales and to try to understand what their maximum capacity is.
If we had looked at only three years of historic financial statements, we would have missed the following three key elements:
The company changed the auditor in the last three years, and the new auditor issued unqualified opinions for all three years, with no comment on historic shenanigans…
Some exceptions from the best practices
There are some exceptions from the best practices presented above:
Whichever solution is applied in the end (hopefully it is not a no-go option!), the analyst always has to look at the forecast which should normally carry more weight in the financial risk assessment. How many years of forecast should be performed is a topic for another article.