Hello, again Martins it is a pleasure to see you. Today we want to get a little bit practical and discuss how to perform financial analysis of crowdlending projects.

OK. Let’s start with the key objective of financial analysis for a lending project – the availability of cash flows to repay the loan and interest. In practice, this will focus on a financial performance indicator called EBITDA or earnings before interest, tax, depreciation, and amortization (for real estate operations a similar indicator is ‘Net operating income’ or NOI). EBITDA is a simplified indicator for ‘cash’ earnings generated by the borrower.

There is another important matter to consider as part of our analysis – are we talking about a separate project or a business operation. For a single project, which is often organized in a separate legal entity, debt liability usually is limited to the assets of this legal entity and there is no sense to analyze other parts of a business group unless there are guarantees linking this project to a wider group. Also, for projects, there is no history, only forecasts. So, the analysis would focus on assumptions used within the forecast to understand whether we believe future targets are achievable.

For a business operation, the financial analysis should cover both historic performance and future outlook, as these might be different. Our aim would be to understand what was the level of regular cash earnings (EBITDA) during the last 3-4 years and what level we can expect during the tenure of the loan.

And we have to analyze cash earnings in the context of the financial position of the company as profit level in isolation will not give a full understanding of whether the company will be able to repay its loan with reasonable certainty.
 

Basically, financial analysts work as crystal balls trying to predict the future. But do we need to analyze all positions and all correlations?

Of course not. Banks usually use around 3-5 ratios to define so-called acceptable risk criteria which is a precondition to applying for a loan and will use them as requirements to keep lending them money.

So, you must at least do the same.

Which ratios do we have to use and how we can calculate them?

I would say that there are two key ratios to use when assessing a lending opportunity.

The first is Debt / EBITDA ratio. As its name suggests, this is a relationship between the total debt (interest-bearing liabilities which include loans, overdrafts, financial lease, and other credit facilities) and its EBITDA. It is important as it shows how big is or will be (after receiving the new loan) the debt burden carried by the company and will its cash earnings be sufficient to service debt payments.

There is always a question of how much is too much, in case of a debt load. And there is no single answer. The healthy ratio will vary by industry. For real estate and capital-intensive infrastructure business ratio around 10 would be normal, but for the majority of businesses, the healthy level is between 3 and 5.

The second ratio is Debt Service Coverage Ratio which shows the relationship between regular debt principal, interest payments and EBITDA (effectively, EBITDA divided by debt principal plus interest). Usually, it is calculated on a 12-months basis to see how well the company can secure its debt service payments. The minimum level for this ratio would be around 1.2. Below that debt service payments appear to be vulnerable to any negative deviations in profit levels.

The other two ratios to also consider are the equity ratio and the current ratio.

The equity ratio is calculated as Equity divided by Total assets and it shows how much funding (or risk) in the company is undertaken by its owners. From a lender’s point of view, it also shows the level of safety buffer in case debt will need to be recovered by selling the assets (as the sales value almost always is lower than the one shown in the balance sheet). So, the higher the ratio, the more safe the company is for a lender. And vice versa, an equity ratio below 15-20% looks fragile.

Finally, it is worth having check on the Current Ratio which is calculated as Current Assets (stock, trade receivables, cash) divided by Current Liabilities (trade payables and debt principal payments within the next 12 months) as this shows the ability of the company to meet its payment obligations within the next 12 months and therefore whether it is solvent in the near term.

Is it really as simple as it sounds – just calculate a few numbers and you have a clear view?

Unfortunately, not really. While the calculation of ratios themselves is not difficult, you would need to understand whether data used for these purposes is good enough.

Firstly, whether financial statements which are used as information sources have been audited. Unaudited financial statements will clearly be less reliable than audited ones.

Secondly, as mentioned before, it is important to look over a period of 3-4 years to see whether profit levels and financial position are consistent. We also need to consider management forecasts (if such are provided) to understand whether historic performance is likely to repeat, or will be better or worse in the future.

Finally, you may want to have your own view on the quality of assets and earnings reported by the management, for example – trade receivable could be difficult to collect or stock difficult to sell (which may appear as high balances compared to the level of sales), profits could be boosted by government grants (very typical during 2020 and 2021 due to government support programs). This will require some digging into the information provided by management within the financial statements and auditors’ reports on these financial statements may also highlight significant uncertainties (read ‘risks’) faced by the company.

I would say that it takes some practice to build skills in this area but, the more you practice, the more financial reports will tell you.

Also, the new EU requirements require platforms to have their own credit risk analysis and share their results with the investors. Some of the platforms do have their own risk ratings and publish them along with the project offer but I can not say that these ratings are always transparent and useful for decision making.

It is very helpful and I believe each platform has to provide such information for investors. Please give final advice to our readers. 

You need to understand the risk that you are taking but it is the platform's job to provide you with detailed information therefore do not hesitate to ask platforms to provide you with their credit risk analysis and its conclusions. 

Thank you very much Martins! It is very valuable information both for investors to understand how they can evaluate project financial risks and platforms to understand what data they have to provide so that investors can make decisions.