Chapter10

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Financial Statement

Analysis

K R SubramanyamJohn J Wild

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10CHAPTER

Credit Analysis

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Liquidity and Working Capital

• Liquidity - Ability to convert assets into cash or to obtain cash to meet short-term obligations.• Short-term - Conventionally viewed as a period up to one year.

• Working Capital - The excess of current assets over current liabilities.

Basics

Lack of liquidity can limit: Severe illiquidity often precedes: Advantages of discounts Lower profitability Profitable opportunities Restricted opportunities Management actions Loss of owner control Coverage of current obligations Loss of capital investment

Insolvency and bankruptcy

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• Current Assets - Cash and other assets reasonably expected to be (1) realized in cash, or (2) sold or consumed, during the longer of one-year or the operating cycle.

• Current liabilities - Obligations to be satisfied within a relatively short period, usually a year.Working Capital - Excess of current assets over current liabilities – Widely used measure of short-term liquidity – Constraint for technical default in many debt agreements– Three common concerns are:

1. Contingent liabilities associated with loan guarantees. 2. Future minimum rental payments under noncancelable operating lease agreements. 3. Contracts for construction or acquisition of long-term assets often call for substantial progress payments.

Basics

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• Current Ratio – Ratio of Current Assets to Current Liabilities– Relevant measure of current liability coverage, buffer against losses,

reserve of liquid funds.– Limitations – A static measure

• Numerator Considerations– Adjustments needed to counter limitations such as:

• Failure to reflect open lines of credit• Adjust securities’ valuation since the balance sheet date• Reflect revolving nature of accounts receivable• Recognize profit margin in inventory• Adjust inventory values to market• Remove deferred charges of dubious liquidity from prepaid

expenses• Denominator Considerations

– Payables vary with sales.– Current liabilities do not include prospective cash outlays.

Current Ratio

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• Liquidity depends to a large extent on prospective cash flows and to a lesser extent on the level of cash and cash equivalents.

• No direct relation between balances of working capital accounts and likely patterns of future cash flows.

• Managerial policies regarding receivables and inventories are directed primarily at efficient and profitable asset utilization and secondarily at liquidity.

• Two elements integral to the use of current ratio:– Quality of both current assets and current liabilities.– Turnover rate of both current assets and current liabilities.

Current Ratio

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• Comparative Analysis – Trend analysis

• Ratio Management (window dressing)– Toward close of a period, management will occasionally press the

collection of receivables, reduce inventory below normal levels, and delay normal purchases.

• Rule of Thumb Analysis (2:1)– Current ratio above 2:1 - superior coverage of current liabilities (but not

too high - inefficient resource use and reduced returns)– Current ratio below 2:1 - deficient coverage of current liabilities

• Note of caution– Quality of current assets and the composition of current liabilities are

more important in evaluating the current ratio.– Working capital requirements vary with industry conditions and the

length of a company’s net trade cycle.

Current Ratio - Applications

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• Net Trade Cycle Analysis

Current Ratio - Applications

Then, the net trade cycle is computed as:

IllustrationSelected information from Technology Resources for the end of Year 1:Sales for Year 1 $360,000Receivables 40,000Inventories* 50,000Accounts payable† 20,000Cost of goods sold (including depreciation of $30,000) 320,000

*Beginning inventory is $100,000.†These relate to purchases included in cost of goods sold.

We estimate Technology Resources’ purchases per day as:Ending inventory $ 50,000Cost of goods sold 320,000

370,000Less: Beginning inventory (100,000)Cost of goods purchased and manufactured 270,000Less: Depreciation in cost of goods sold (30,000)Purchases $240,000Purchases per day = $240,000/360 = $666.67

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• Cash to Current Assets Ratio

– Larger the ratio, the more liquid are current assets

• Cash to Current Liabilities Ratio

– Larger the ratio, the more cash available to pay current obligations

Cash-Based Ratio Measures of Liquidity

Cash + Cash equivalents + Marketable securities Current Assets

Cash + Cash equivalents + Marketable securities Current Liabilities

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Operating Activity Analysis of Liquidity

• Accounts Receivable Turnover

• Days’ Sales in Receivables

• Receivables collection period

Accounts Receivable Liquidity Measures

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• Accounts receivable turnover rates and collection periods are usefully compared with industry averages or with credit terms.

• Ratio Calculation: Gross or Net?• Trend Analysis

– Collection period over time.– Observing the relation between the provision for

doubtful accounts and gross accounts receivable.

Interpretation of Receivables Liquidity Measures

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Illustration (Day’s sales in inventory)


• Inventory turnover ratio:

– Measures the average rate of speed at which inventories move through and out of a company.

• Days’ Sales in Inventory:

– Shows the number of days required to sell ending inventory

• An alternative measure - Days to sell inventory ratio:

Inventory Turnover Measures

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– Quality of inventory– Decreasing inventory turnover

• Analyze if decrease is due to inventory buildup in anticipation of sales increases, contractual commitments, increasing prices, work stoppages, inventory shortages, or other legitimate reason.

– Inventory management – Effective inventory management increases inventory

turnover.

Interpreting Inventory Turnover

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– Conversion period or operating cycle:

• Measure of the speed with which inventory is converted to cash

Interpreting Inventory Turnover

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• Current liabilities are important in computing working capital and current ratio: – Used in determining whether sufficient margin of safety exists.– Deducted from current assets in arriving at working capital.

• Quality of Current Liabilities – Must be judged on their degree of urgency in payment– Must be aware of unrecorded liabilities having a claim on

current funds

Liquidity of Current Liabilities

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• Days’ Purchases in Accounts Payable

– Measures the extent accounts payable represent current and not overdue obligations.

• Accounts Payable Turnover

– Indicates the speed at which a company pays for purchases on account.

Days’ Purchases in Accounts Payable

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Additional Liquidity Measures

– Indicator of working capital liquidity Illustration

Current Assets Composition

Texas Electric’s current assets along with their common-size percentages are reproduced below for Years 1 and 2:Cash $ 30,000 30 % $ 20,000 20 %Accounts receivable 40,000 40 30,000 30Inventories 30,000 30 50,000 50 %Total current assets $100,000 100 % $100,000 100

An analysis of Texas Electric’s common-size percentages reveals a marked deterioration in current asset liquidity in Year 2 relative to Year 1. This is evidenced by a 10% decline for both cash and accounts receivable.

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Additional Liquidity Measures• Acid-Test (Quick) Ratio - A more stringent test of

liquidity

• Cash Flow Measures– Cash Flow Ratio

– Overcomes the static nature of the current ratio since its numerator reflects a flow variable.

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Additional Liquidity Measures• Financial Flexibility - Ability to take steps to counter

unexpected interruptions in the flow of funds.– Ability to borrow from various sources; to raise equity capital; to

sell and redeploy assets; to adjust the level and direction of operations to meet changing circumstances; levels of prearranged financing and open lines of credit

• Management’s Discussion and Analysis – MD&A requires a discussion of liquidity –

including known trends, demands, commitments, or uncertainties likely to impact the company’s ability to generate adequate cash.

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• Technique to trace through the effects of changes in conditions/ policies on cash resources of a company

What-if analysis

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Additional Liquidity MeasuresWhat-if analysis Illustration

Background Data—Consolidated Technologies at December 31, Year 1:

Cash $ 70,000Accounts receivable 150,000Inventory 65,000Accounts payable 130,000Notes payable 35,000Accrued taxes 18,000Fixed assets 200,000Accumulated depreciation 43,000Capital stock 200,000

The following additional information is reported for Year 1:

Sales $750,000Cost of sales 520,000Purchases 350,000Depreciation 25,000Net income 20,000

Anticipates 10 percent growth in sales for Year 2 All revenue and expense items are expected to increase by 10 percent, except for depreciation,

which remains the same All expenses are paid in cash as they are incurred Year 2 ending inventory is projected at $150,000 By the end of Year 2, predicts notes payable of $50,000 and a zero balance in accrued taxes Maintains a minimum cash balance of $50,000

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Case 1: Consolidated Technologies is considering a change in credit policy where ending accounts receivable reflect 90 days of sales. What impact does this change have on the company’s cash balance? Will this change affect the company’s need to borrow?

Our analysis of this what-if situation is as follows:Cash, January 1, Year 2 $ 70,000Cash collections: Accounts receivable, January 1, Year 2 $ 150,000 Sales 825,000 Total potential cash collections $ 975,000 Less: Accounts receivable, December 31, Year 2 ( 206,250)(a) 768,750 Total cash available $ 838,750Cash disbursements: Accounts payable, January 1, Year 2 $ 130,000 Purchases 657,000(b) Total potential cash disbursements $ 787,000 Accounts payable, December 31, Year 2 ( 244,000)(c) $ 543,000 Notes payable, January 1, Year 2 $ 35,000 Notes payable, December 31, Year 2 ( 50,000) (15,000) Accrued taxes 18,000 Cash expenses(d) 203,500 749,500Cash, December 31, Year 2 $ 89,250Cash balance desired 50,000Cash excess $ 39,250

(continued)


What-if analysis - Illustration

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Explanations:(a)

(b)Year 2 cost of sales*: $520,000 × 1.1 = $572,000 Ending inventory (given) 150,000 Goods available for sale $ 722,000 Beginning inventory (65,000) Purchases $ 657,000 * Excluding depreciation.(c)

(d) Gross profit ($825,000 – $572,000) $ 253,000 Less: Net income $ 24,500* Depreciation 25,000 ( 49,500) Other cash expenses $203,500 *110 percent of $20,000 (Year 1 N.I.) + 10 percent of $ 25,000 (Year 1 depreciation).


What-if analysis - Illustration

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Basics of Solvency• Solvency — long-run financial viability and its ability to

cover long-term obligations• Capital structure — financing sources and their

attributes• Earning power — recurring ability to generate cash from

operations• Loan covenants — protection against insolvency and

financial distress; they define default (and the legal remedies available when it occurs) to allow the opportunity to collect on a loan before severe distress

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Basics of Solvency

• Equity financing– Risk capital of a company– Uncertain and unspecified return– Lack of any repayment pattern– Contributes to a company’s stability

and solvency

• Debt financing– Must be repaid with interest– Specified repayment pattern

• When the proportion of debt financing is higher, the higher are the resulting fixed charges and repayment commitments

Capital Structure

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Basics of Solvency

• From a shareholder’s perspective, debt is a preferred external financing source: – Interest on most debt is fixed – Interest is a tax-deductible expense

• Financial leverage - the amount of debt financing in a company’s capital structure. – Companies with financial leverage are said to be

trading on the equity.

Motivation for Debt

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Basics of SolvencyFinancial Leverage- Illustrating Tax Deductibility of Interest

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Other Effects of Leverage

• Avoid earnings per share dilution.• More profitable when interest rates are

increasing. • In times of inflation, monetary liabilities

yield price-level gains.

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Adjustments for Capital Structure Analysis

• The relation between liabilities and equity capital, the two major sources of a company’s financing, is an important factor in assessing long-term solvency.

• There exists liabilities not fully reflected in balance sheets, and there are financing-related items whose accounting classification as debt or equity must not be blindly accepted in our analysis. Our identification and classification of these items depend on a thorough understanding of their economic substance and the conditions to which they are subject.

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Basics of Solvency

Potential accounts needing adjustments Chapter reference

• Deferred Income Taxes - Is it a liability, 3 & 6equity, or some of both? To th extent future reversals are a remote

possibility, as conceivable with timing differences from accelerated depreciation, deferred taxes should be viewed like long-term financing and treated like equity. However, if the likelihood of a drawing down of deferred taxes in the forceable future is high, then deferred taxes (or part of them) should be treated like long-term liabilities.

• Operating Leases - capitalize non- 3cancelable operating leases?

Adjustments for Capital Structure - Liabilities

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• Off‑Balance‑Sheet Financing: SPU and equity invvestment 3

• Contingent Liabilities: Product gaurantees and waranties 3 &

6• Minority Interests: more like outsiders’ claims to aportion of

capital or an offset representing their proportionate ownership of assets. 5

• Convertible Debt 3• Preferred Stock 3

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Capital Structure Composition and Solvency

• Composition analysis – Performed by constructing a common-size statement of the

liabilities and equity section of the balance sheet. – Reveals relative magnitude of financing sources.

Tennessee Teletech’s Capital StructureCommon-Size AnalysisCurrent liabilities $ 428,000 19 %Long-term debt 500,000 22.2Equity capital Preferred stock 400,000 17.8 Common stock 800,000 35.6 Paid-in capital 20,000 0.9 Retained earnings 102,000 4.5Total equity capital 1,322,000 58.8Total liabilities and equity $2,250,000 100 %

Common-Size Statements in Solvency Analysis

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• Total Debt to Total Capital Ratio– Comprehensive measure of the relation between total debt and

total capital – Also called Total debt ratio

• Total Debt to Equity Capital• Long-Term Debt to Equity Capital

– Measures the relation of LT debt to equity capital.– Commonly referred to as the debt to equity ratio.

• Short-Term Debt to Total Debt– Indicator of enterprise reliance on short-term financing. – Usually subject to frequent changes in interest rates.

Capital Structure Ratios

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• Capital structure measures serve as screening devices.

• Further analysis required if debt is a significant part of capitalization.

Interpretation of Capital Structure Measures

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• Asset composition in solvency analysis– Important tool in assessing capital structure risk exposure.– Typically evaluated using common-size statements of asset

balances.

Asset-Based Measures of Solvency

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Earnings Coverage

• Limitation of capital structure measures - inability to focus on availability of cash flows to service debt.

• Role of earnings coverage, or earning power, as the source of interest and principal repayments. As debt is repaid, capital structure measures improve, whereas annual cash requirements for paying interest or sinking funds remain fixed or increase.

• Earnings to fixed charges ratio

Earnings to Fixed Charges

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Earnings Coverage• What level of income is most representative of the

amount actually available in future periods for paying debt-related fixed charges?

• Average earnings from continuing operations that span the business cycle and are adjusted for likely future changes are probably a good approximation of the average cash available from future operations to pay fixed charges.

• Fixed charges include: Interest incurred, Interest implicit in lease obligations, Preferred stock dividend requirements of minority-owned subsidiaries, principal payment requirements, guarantees to pay fixed charges.

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Earnings CoverageEarnings to Fixed Charges

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Earnings to Fixed Charges Ratio Calculation:

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Earnings Coverage

• Times interest earned ratio – Considers interest as the only fixed charge needing

earnings coverage:

– Numerator sometimes referred to as earnings before interest and taxes, or EBIT.

– Potentially misleading and not as effective an analysis tool as the earnings to fixed charges ratio.

Times Interest Earned

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Earnings Coverage

• Cash flow to fixed charges ratio – Computed using cash from operations rather than

earnings in the numerator of the earnings to fixed charges ratio.

Relation of Cash Flow to Fixed Charges

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Earnings Coverage

• Earnings coverage of preferred dividends ratio– Computation must include in fixed charges all expenditures

taking precedence over preferred dividends. – Since preferred dividends are not tax deductible, after-tax

income must be used to cover them.

Earnings Coverage of Preferred Dividends

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Earnings Coverage

– Earnings coverage measures provide insight into the ability of a company to meet its fixed charges

– High correlation between earnings-coverage measures and default rate on debt

– Earnings variability and persistence is important– Use earnings before discontinued operations,

extraordinary items, and cumulative effects of accounting changes for single year analysis — but, include them in computing the average coverage ratio over several years

Interpreting Earnings Coverage

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Earnings Coverage

• A company can increase risks (and potential returns) of equity holders by increasing leverage

• Substitution of debt for equity yields a riskier capital structure

• Relation between risk and return in a capital structure exists

• Only personal analysis can reflect one’s unique risk and return expectations

Capital Structure Risk and Return

Return$

Risk?

Chapter10

Business

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