What is the accompanying letter for annual financial statements?
The cover letter accompanying financial statements is a separate document intended to provide readers with important context. It explains information in a way that is tailored to the target audience and presents it in the right light. In addition to the actual core message, the appropriate framework and classification of the statements are often essential for conveying the right message. The accompanying letter to an annual financial statement aims to achieve precisely this and provide the reader with a classification of a company’s annual financial statements tailored to the target audience. This is because entrepreneurs and banks or rating agencies view the same annual financial statements from two completely different perspectives.
The correct classification of one-off income on credit assessment
While some business transactions, such as insurance payments for costs incurred or income from previous periods, are compensation for costs already incurred for entrepreneurs, exactly the same circumstances are an item that banks need to reduce. This is because bank analysts are not familiar with the circumstances of the respective cases.
From the perspective of an outside third party, these are, in case of doubt, one-off earnings, but the focus of the banks is more on long-term earning power (“Is the company able to repay the loan from its operating business without special effects?”). The added value of an externally prepared accompanying letter is that it classifies precisely such circumstances and places them in the right context. For example, insurance compensation may be offset by costs, which is why one cannot be considered without the other.
In the example given, in order for the bank to assess whether a company can repay its loan from its operating business, either the extraordinary income and extraordinary expenses for the claim would have to be eliminated, or both would have to be retained. This would not change the net contribution to earnings and therefore would not affect the assessment of whether a company can repay its loan. This example clearly shows that the correct classification of these items can have a significant impact on a company’s rating.
Good ratings made easy
In addition to classifying specific circumstances, an indicative rating for the companies is also prepared as part of the cover letter—ideally before the reporting date, using forecast values. Relevant earnings, balance sheet, and liquidity ratios are used for this purpose.
This indicative rating also allows optimization potential to be identified and implemented. This enables entrepreneurs to proactively influence the rating in a positive way rather than reacting after receiving a poor rating and taking countermeasures for the next fiscal year. Furthermore, due to the large number of different rating indicators, optimization is not trivial. By creating the indicative rating, measures to improve the rating and a potential effect on the rating can be simulated. This applies to both short-term optimization (e.g., payment of liabilities directly before the end of the fiscal year in order to report the highest possible equity ratio on the reporting date) and medium-term opportunities (e.g., gradual conversion of financing from leasing to hire purchase in order to increase the “EBITDA” indicator).
An indicative rating also helps during the annual meeting with financing partners.
If the company has already dealt with the issues in depth in advance, it will be easier to convince the financing partner of the different interpretations of facts during the annual meeting.
Keyword: Debt servicing capacity
For banks in particular, debt servicing capacity is an extremely important key figure. Operating income is adjusted for non-cash effects to calculate operating cash flow. This operating cash flow is then compared with the debt servicing required, i.e., the interest and principal payments to be made.
This can also be simulated as part of the rating process, and measures to improve debt servicing capacity can be derived. It is advisable to prepare the debt servicing analysis in good time so that countermeasures can be implemented effectively before the deadline.
Philip Herrmann
