Lecture 09

Long term Debt and Solvency Analysis

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Financial StatementsJust like a doctor takes a look at a patient’s x-rays when diagnosing health problems, a manager or analyst can take a look at a firm’s primary financial statements, the income statement and the balance sheet, when trying to gauge the status or performance of a firm.

Income statement: periodic recording of the sources of revenue and of a firm, Balance sheet: provides a point in time snap shot

of the firm’s and owner’s equity.

Financial Ratios• Financial ratios are relationships between

different accounts from financial statements—usually the income statement and the balance sheet—that serve as performance indicators

• Being relative values, financial ratios allow for meaningful comparisons across time, between competitors, and with industry averages.

Financial RatiosFIVE key areas of a firm’s performance can be analyzed using financial ratios:

1. Liquidity ratios: Can the company meet its obligations over the short term?2. Solvency ratios: (also known as financial leverage ratios): Can the company meet its obligations over the long term?3. Asset management ratios: How efficiently is the company managing its assets to generate sales?4. Profitability ratios: How well has the company performed overall?5. Market value ratios: How does the market (investors) view the company’s financial prospects?

Solvency Ratio

• A ratio that measure's an enterprise’s ability to meet its debt and other obligations.

• The solvency ratio indicates whether a company’s cash flow is sufficient to meet its short-term and long-term liabilities.

• The lower a company's solvency ratio, the greater the probability that it will default on its debt obligations.

Short-Term Solvency: Liquidity Ratios

• Measure a company’s ability to cover its short-term obligations in a timely manner:

• 3 key liquidity ratios include: The current ratio, quick ratio, and cash ratio.

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Short-Term Solvency: Liquidity Ratios

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Cogswell has better liquidity and short-term solvency than Spacely, but, higher investment in current assets also means that lower yields arebeing realized since current assets are typically low yielding. So, we need to look at the other areas and inter-related effects of the firm’s various accounting items.

Long-Term Solvency: Financial Leverage Ratios

• Measure a company’s ability to meet its long-term debt obligations based on its overall debt level and earnings capacity.

• Failure to meet its interest obligation could put a firm into bankruptcy.• Solvency is a company’s ability to meet the

obligations created by its long-term debt.

Long Term Debt• Long-term debt consists of loans and

financial obligations lasting over one year. • Long-term debt for a company would

include any financing or leasing obligations that are to come due in a greater than 12-month period.

• Long-term debt also applies to governments: nations can also have long-term debt.

Long-Term Solvency: Financial Leverage Ratios

• There are four major long term solvency ratio that helps in measuring the firms long term health.

1.Debt to Equity ratio2.Total equity to total assets ratio3.Capitalization ratio4.Interest coverage ratio

Earning per share and other ratios used in valuation

Earning per share (EPS)

• The portion of a company's profit allocated to each outstanding share of common stock.

• Earnings per share serves as an indicator of a company's profitability. It is the most commonly used corporate performance statistic for publicly traded firms.

• Used to compare operating performance and valuation of market price as P/E ration.

• EPS can be calculated as