11
CHAPTER
Credit Analysis
Company Liquidity refers to the ability to meet short-
term obligations
Liquidity is the ability to convert
assets into cash or to
obtain cash
Short term is the longer of one-year
or the company operating cycle
Liquidity and Working Capital
Basics
Liquidity is a matter of degree
Lack of liquidity can limit
? Advantages of favorable discounts
? Profitable opportunities
? Management actions
? Coverage of current obligations
Liquidity and Working Capital
Basics
Severe illiquidity often precedes
? Lower profitability
? Restricted opportunities
? Loss of owner control
? Loss of capital investment
? Insolvency and bankruptcy
Liquidity and Working Capital
Basics
Current assets are 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 company’s operating cycle
Current assets include,
Cash -- ultimate liquid asset
Cash equivalents -- temporary investments of excess cash
Marketable securities -- debt or equity securities held as s-t investments
Accounts receivable -- mounts due from credit sales
Inventories -- items held for sale in the normal course of business
Prepaid expenses -- advance payments for services and supplies
Liquidity and Working Capital
Current Assets
Classification as current asset
depends on,
1,Manament’s intent
2,Industry practice
Analysis must assess this classification
1,Is classification as current asset appropriate?
2,If not,then adjust accounts and amounts among current
and noncurrent
Liquidity and Working Capital
Current Assets
Balance
Sheet
Classification as current liability depends on,
1,Manament’s intent
2,Industry practice
Analysis must assess this classification
1,Is classification as current liability appropriate?
2,If not,then adjust accounts and amounts among current and noncurrent
3,Are current liabilities reported?
4,If not,then adjust accounts for these amounts—potential examples,
? Contingent liabilities associated with loan guarantees
? Future minimum rental payments under noncancelable operating leases
? Progress payments under contracts
? Current deferred tax liabilities (and assets)
Liquidity and Working Capital
Current Liabilities
Working capital is
? defined as the excess of current assets over current liabilities
? Widely used measure of short-term liquidity
? Deficient when current liabilities exceed current assets
? In surplus when current assets exceed current liabilities
? A margin of safety for creditors
? A liquid reserve to meet contingencies and uncertainties
? A constraint for technical default in many debt agreements
Liquidity and Working Capital
Working Capital
Working capital more relevant when related to other key
variables such as
? Sales
? Total assets
Working capital is of limited value as an absolute
amount
Liquidity and Working Capital
Working Capital
Current Ratio Reflects on,
? Current liability coverage -- assurance in covering current
liabilities
? Buffer against losses -- margin of safety for shrinkage in
noncash current assets
? Reserve of liquid funds --margin of safety
against uncertainties and shocks to cash flows
Liquidity and Working Capital
Current Ratio
sl i a b i l i t i e C u r r e n t
a s s e t s C u r r e n t=r a t i o C u r r e n t
Current Ratio — Limitations,
If liquidity is the ability to meet cash outflows with adequate
cash inflows,then does the current ratio,
? Measure and predict the pattern of future cash inflows and
outflows?
? Measure the adequacy of future cash inflows to outflows?
Answer is generally no to both these questions
Current ratio
? Is a static measure
? Does not have a causal relation to future
cash inflows
Liquidity and Working Capital
Current Ratio
Current Ratio — Limitations in Numerator
Adjustments often needed to counter various 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
Liquidity and Working Capital
Current Ratio
Three important qualifications
1,Liquidity depends to a large extent on prospective cash
flows
2,No direct relation between working capital account
balances and patterns of future cash flows
3,Managerial policies are directed primarily at efficient and
profitable asset utilization and secondly at liquidity
4,Cash flow forecasts and pro forma financial statements
are preferred over the current ratio for liquidity and
solvency analysis
5,Current ratio is a static measure of the ability of current
assets to satisfy current liabilities
Liquidity and Working Capital
Current Ratio
Two important elements are integral to use of the current
ratio
1,Quality of both current assets and current liabilities
2,Turnover rate of both current assets and current
liabilities
Liquidity and Working Capital
Current Ratio
Comparative Analysis
Two useful tools in analyzing
the trend in the current ratio
Trend analysis -- components of working capital and the
current ratio are converted to indexes and examined over
time
Common-size analysis -- composition of current assets is
examined over time
Liquidity and Working Capital
Current Ratio - Applications
Ratio Management (window dressing)
Examples are,
? Press the collection of
receivables at year-end
? Call in advances to officers for
temporary repayment
? Reduce inventory below normal
levels
? Delay normal purchases
Proceeds from these activities are then
used to pay off current liabilities
Liquidity and Working Capital
Current Ratio - Applications
Rule of Thumb Analysis (2:1)
> 2:1 ? superior coverage of current liabilities (but not
too high,suggesting inefficient use of resources
and reduced returns)
< 2:1 ? deficient coverage of current liabilities
Liquidity and Working Capital
Current Ratio - Applications
Net Trade Cycle Analysis
Working capital requirements are affected by its desired
inventory investment and the relation between credit
terms from suppliers and those extended to customers
Liquidity and Working Capital
Current Ratio - Applications
Net Trade Cycle— Illustration
Selected financial information from Technology Resources,Inc.,for the end of Year 1 is
reproduced below,
Sales for Year 1 $360,000
Receivables 40,000
Inventories* 50,000
Accounts payable? 20,000
Cost of goods sold
(including depreciation of $30,000) 320,000
*Beginning inventory is $100,000,
?We assume these relate to purchases included in cost of goods sold,
We estimate Technology Resources’ purchases per day as,
Purchases per day = $240,000 ÷ 360 = $666.67
The net trade cycle for Technology Resources is computed as (in days),
Liquidity and Working Capital
d a y s 6 6, 2 4=( d a y s ) c y c l e t r a d e N e t
d a y s 3 0, 0 0=
$ 6 6 6, 6 7
$ 2 0,0 0 0
=p a y a b l e A c c o u n t s:L e s s
d a y s 9 6, 2 4
d a y s 5 6, 2 4=
360$ 3 2 0,0 0 0
$ 5 0,0 0 0
=sI n v e n t o r i e
d a y s 4 0, 0 0=
360$ 3 6 0,0 0 0
$ 4 0,0 0 0
=r e c e i v a b l e A c c o u n t s
?
?
Current Ratio - Applications
Sales Trend Analysis
Trend analysis — review of sales trend across time
Liquidity and Working Capital
Current Ratio - Applications
Cash to Current Assets Ratio
Larger the ratio,the more liquid are current assets
Liquidity and Working Capital
Cash-Based Ratio of Liquidity
a s s e t s C u r r e n t
s e c u r i ti e s M a r k e t a b l e+se q u i v a l e n t C a s h+C a s h
Cash to Current Liabilities Ratio
Larger the ratio,the more cash available to pay current
obligations
Liquidity and Working Capital
sl i a b i l i ti e C u r r e n t
s e c u r i ti e s M a r k e t a b l e+se q u i v a l e n t C a s h+C a s h
Cash-Based Ratio of Liquidity
Accounts Receivable Turnover
Operating Activity Analysis of Liquidity
Accounts Receivable Liquidity
r ec ei v ab le ac c ou nts A v er ag e
c r edi t on s al es N et
Operating Activity Analysis of Liquidity
Accounts Receivable Liquidity
R e c e i v a b l e s T u r n o v e r f o r S e l e c t e d I n d u s t r i e s
0 20 40 60 80 100 120 140
F o o d s t o re s
Ea t i n g a n d d ri n k i n g
M o t i o n p i c t u re s
Pri n t i n g a n d p u b l i s h i n g
El e c t ri c a l e q u i p m e n t
Ed u c a t i o n a l s e rv i c e s
G e n e ra l m e rc h a n d i s e
R e c e i v a b l e s tu r n o v e r
Source,Dun & Bradstreet
Accounts Receivable Collection Period
Operating Activity Analysis of Liquidity
Accounts Receivable Liquidity
t u r n o v e r r e c e i v a b l e A c c o u n t s
3 6 0=p e r i o d C o l l e c t i o n
Days’ Sales in Receivables (Alternative to Collection Period)
Operating Activity Analysis of Liquidity
Accounts Receivable Liquidity
360
S a l e s R e c e i v a b l e A c c o u n t ?
Temporal Trend Analysis
Trend in,
1,Collection period over time
2,
Operating Activity Analysis of Liquidity
Accounts Receivable Liquidity
r e c e i v a b l e a c c o u n t s G r o s s
a c c o u n t s d o u b t f u l f o r P r o v i s i o n
Inventory Turnover
Measures the average rate of speed inventories move
through and out of a company
Operating Activity Analysis of Liquidity
Inventory Turnover
inv en tor y A v er ag e
s ol d goods of C os t
Days to Sell Inventory
Useful in assessing purchasing and production policies—shows the number of
days a company takes in selling average inventory for that year
Alternative computation-- Days’ Sales in Inventory
where the cost of average day’s sales is,
Shows the number of days required to sell ending inventory
Operating Activity Analysis of Liquidity
Inventory Turnover
tu r no v erIn v en to r y
36 0
s al es sday ' av er age of C os t
inv entor y E ndi ng
360
s o l d goods of C o s t
Selected financial information from Macon Resources,Inc.,for the end of
Year 8 is reproduced below,
Sales $1,800,000
Cost of goods sold 1,200,000
Beginning inventory 200,000
Ending inventory 400,000
Inventory turnover ratios using average inventory are computed as,
Inventory turnover ratios based on ending inventory equal,
Operating Activity Analysis of Liquidity
Inventory Turnover - Illustration
day sD ay s
I nv e nt or y
90
4
2)000,400$000,200($
?
?
?
?
4
3 6 0=r a t i oi n v e n t o r y se l l to
$ 1,2 0 0,0 0 0=r a t i o t u r n o v e r
da y s
$ 3,3 3 3
$ 4 0 0,0 0 0=i n v e n t o r y in sa l e s D a y s'
$ 1,2 0 0,0 0 0=sa l e s sd a y ' a v e r a g e of C o st
120
333,3$
360
?
?
Conversion Period (Operating Cycle),
Days’ to Sell Inventory + Collection Period
Measure of the speed with which inventory is converted
to cash
Operating Activity Analysis of Liquidity
Inventory Turnover
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
Operating Activity Analysis of Liquidity
Liquidity of Current Liabilities
Days’ Purchases in Accounts Payable
Measures the extent accounts payable represent current
and not overdue obligations
Operating Activity Analysis of Liquidity
Inventory Turnover
3 6 0P u r c h a s e s
p a y a b l e A c c o u n t s=p a y a b l e a c c o u n t s in p u r c h a s e s Days’ ?
Additional Liquidity Measures
Asset Composition
Composition of current
assets is an indicator of
working capital liquidity
Use of common-size
percentage comparisons
facilitates this analysis
Balance
Sheet
Liquidity Index
Expressed in days and its computation is a weighting
mechanism
Analysis of Index must involve comparative analyses,
? Measure of period-to-period change in liquidity
? Measure of relative liquidity across companies
Increases signify a deterioration in liquidity
Decreases signify improved liquidity
Additional Liquidity Measures
Liquidity Index - Illustration
Using the financial data of Texas Electric,we find their
conversion of inventories into accounts receivable takes 50
days (on average) and their conversion of receivables into
cash takes 40 days (on average),The liquidity index for
Texas Electric is computed as,
Year 1,
Amount x Days Removed = Product
from Cash Dollar x Days
Cash $ 30,000 — —
Accounts receivable 40,000 40 days 1,600,000
Inventories 30,000 90 days 2,700,000
Total $100,000 (a) 4,300,000 (b)
d a y s 43=
$ 1 0 0,0 0 0
4,3 0 0,0 0 0==i n d e x
a
b
L iq u id it y
Additional Liquidity Measures
Acid-Test (Quick) Ratio
sl i a b i l i t i e C u r r e n t
r e c e i v a b l e A c c o u n t s+s e c u r i t i e s M a r k e t a b l e+se q u i v a l e n t C a s h+C a s h
Is a more stringent test of liquidity
vis-à-vis current ratio
Additional Liquidity Measures
D u n & B r ad str ee t' s Qu i ck R ati o fo r Sel ec ted
I n d u str i es
0 0, 3 0, 6 0, 9 1, 2 1, 5
Food store s
Ea ting an d dr ink ing
Moti on p ictu re s
Pri ntin g a nd p ubli shi ng
Ele ctri cal e quip m e nt
Edu cat iona l se rv ice s
Ge ne ral m e rch and ise
R a t i o
Acid-Test (Quick) Ratio
Additional Liquidity Measures
Source,Dun & Bradstreet
(Cash + Account Receivables/Current Liabilities)
Cash Flow Measures
Cash Flow Ratio
A ratio of 0.40 or higher is common for
healthy companies
sl i a b i l i t i e C u r r e n t
f l o w c a s h O p e r a t i n g
Additional Liquidity Measures
Financial Flexibility
Financial flexibility - ability of a company to take steps
to counter unexpected interruptions in the flow of funds
Focus of analysis,
? 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
Additional Liquidity Measures
Management’s Discussion and Analysis
MD&A requires a discussion of liquidity — including
? Known trends
? Demands
? Commitments
? Uncertainties
? Ability to generate cash
? Internal and external sources of liquidity
? Any material unused sources of liquid assets
Additional Liquidity Measures
Additional Liquidity Measures
What-If Analysis
What-if analysis -- technique to trace through the
effects of changes in conditions or policies on the
cash resources of a company
What-If Analysis - Illustration
Background Data—Consolidated Technologies at December 31,Year 1,
Cash $ 70,000
Accounts receivable 150,000
Inventory 65,000 Accounts payable 130,000
Notes payable 35,000
Accrued taxes 18,000
Fixed assets 200,000
Accumulated depreciation 43,000
Capital stock 200,000
The following additional information is reported for Year 1,
Sales $750,000
Cost of sales 520,000
Purchases 350,000
Depreciation 25,000
Net 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
Additional Liquidity Measures
What-If Analysis - Illustration
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 $ 70,000
Cash 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 $ 838,750
Cash 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) 203,500 749,500
Cash,December 31,Year 2 $ 89,250
Cash balance desired 50,000
Cash excess $ 39,250
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),
Additional Liquidity Measures
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
Basic of Solvency
Facts
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
Basic of Solvency
Capital Structure
From a shareholder’s perspective,debt financing is less
expensive than equity financing because,
1.Financial Leverage--Interest on most
debt is fixed,and provided interest is
less than the return earned from debt
financing,the excess return goes to
equity investors
2.Tax Deductibility of Interest--Interest is
a tax-deductible expense whereas
dividends are not
Basic of Solvency
Motivation for Debt
Leverage -- use of debt to increase net income
Leverage,
? Magnifies both managerial success (profits) and failure
(losses)
? Increases risks
? Limits flexibility in pursuing opportunities
? Decreases creditors’ protection against loss
Companies with leverage are said to be trading on the equity
— omplying a company is using equity financing to obtain debt
financing in a desire to reap returns above the cost of debt,
Basic of Solvency
Financial Leverage
Trading on the Equity—Returns for Different Earnings Levels ($ thousands)
Financing Sources Return on
Income before
Interest and 10 Percent Net Net Income + [Interest
Assets Debt Equity Taxes Debt Interest Taxes* Income (1 - Tax Rate)] Assets? Equity?
Year 1,
Risky,Inc,$1,000,000 $400,000 $600,000 $200,000 $40,000 $64,000 $96,000 $120,000 12.0% 16.0%
Safety,Inc,1,000,000 1,000,000 200,000 80,000 120,000 120,000 12.0 12.0
Year 2,
Risky,Inc,1,000,000 400,000 600,000 100,000 40,000 24,000 36,000 60,000 6.0 6.0
Safety,Inc,1,000,000 1,000,000 100,000 40,000 60,000 60,000 6.0 6.0
Year 3,
Risky,Inc,1,000,000 400,000 600,000 50,000 40,000 4,000 6,000 30,000 3.0 1.0
Safety,Inc,1,000,000 1,000,000 50,000 20,000 30,000 30,000 3.0 3.0
* Tax rate is 40 percent,
? Return on assets = Net income + Interest (1 – 0.40)/Assets,
? Return on equity = Net income/Shareholders’ equity,
Basic of Solvency
Financial Leverage - Illustration
Consider two companies’ results for Year 2,
Year 2 Financials Risky,Inc,Safety,Inc,
Income before interest and taxes $ 100,000 $ 100,000
Interest (10% of $400,000) 40,000 —
Income before taxes $ 60,000 $ 100,000
Taxes (40%) 24,000 40,000
Net income $ 36,000 $ 60,000
Add back interest paid to bondholder 40,000 —
Total return to security holders
(debt and equity) $ 76,000 60,000
Basic of Solvency
Financial Leverage- Illustrating Tax Deductibility
of Interest
Financial Leverage Index
> 1.0 ? favorable effects from leverage
< 1.0 ? unfavorable effects from leverage
= 1.0 ? neutral effects from leverage
Basic of Solvency
Financial Leverage
a s s e t s on R e t u r n
e q u i t y c o m m o n on R e t u r n
Basic of Solvency
Financial Leverage
F i n a n c i a l L e v e r a g e I n d e x
0, 0 0, 5 1, 0 1, 5 2, 0 2, 5
Food store s
Ea ting an d dr ink ing
Moti on p ictu re s
Pri ntin g a nd p ubli shi ng
Ele ctri cal e quip m e nt
Edu cat iona l se rv ice s
Ge ne ral m e rch and ise
I n d e x
Source,Dun & Bradstreet
F i n a n c i a l L e v e r a g e R a t i o
0, 0 0, 5 1, 0 1, 5 2, 0 2, 5
Food store s
Ea ting an d dr ink ing
Moti on p ictu re s
Pri ntin g a nd p ubli shi ng
Ele ctri cal e quip m e nt
Edu cat iona l se rv ice s
Ge ne ral m e rch and ise
R a t i o
Basic of Solvency
Financial Leverage
Source,Dun & Bradstreet
Financial Leverage Ratio
Greater the proportion of financing from equity vs,debt
? lower the financial leverage ratio
Note,Financial leverage ratio is a component
of the disaggregated return on equity
— see Chapter 8
Basic of Solvency
Financial Leverage
c api t alequi t y C om m on
as s et s T ot al
Potential accounts needing adjustments Chapter reference
Deferred Income Taxes — Is it a liability,3 & 6
equity,or some of both?
Operating Leases -- capitalize non- 3
cancelable operating leases?
Off-Balance-Sheet Financing 3
Pensions and Postretirement Benefits 3
Unconsolidated Subsidiaries 5
Contingent Liabilities 3 & 6
Minority Interests 5
Convertible Debt 3
Preferred Stock 3
Basic of Solvency
Adjustments for Capital Structure - Liabilities
Balance
Sheet
Potential accounts needing adjustments Chapter reference
Inventories—LIFO Reserve? 4
Marketable Securities 4
Intangible Assets 4 & 5
Basic of Solvency
Adjustments for Capital Structure - Assets
Balance
Sheet
Projection of Future Cash Inflows and Outflows
Reflects on risk for a levered company’s capital structure
Prepare a Statement of Forecasts of Cash Inflows and
Outflows
Capital Structure and Solvency
Long-Term Projections
Chapter 10 described and illustrated long-term cash flow forecasts
Capital structure composition analysis
? Performed by constructing a common -
size statement of liabilities and equity
? Reveals relative magnitude of financing sources
? Allows direct comparisons across different
companies
? Two Variations—(1) Use ratios,and (2) Exclude current
liabilities
Capital Structure and Solvency
Common-Size Statements
Total Debt to Total Capital (also called total debt ratio)
Capital Structure and Solvency
Capital Structure Measures
c a p i ta l
d e b t T o ta l
T o ta l
Capital Structure and Solvency
Capital Structure Measures
L o n g - T e r m D e b t t o E q u i t y R a t i o
0, 0 0, 1 0, 2 0, 3 0, 4 0, 5
Food store s
Ea ting an d dr ink ing
Moti on p ictu re s
Pri ntin g a nd p ubli shi ng
Ele ctri cal e quip m e nt
Edu cat iona l se rv ice s
Ge ne ral m e rch and ise
R a t i o
Source,Dun & Bradstreet
Total Debt to Equity Capital
Reciprocal measure of this ratio—Equity Capital to
Total Debt
Capital Structure and Solvency
Capital Structure Measures
equ i t y s har eho l der
debt T ot al
S
debt T o t a l
e q u i t y s h a r e h o l d e rS
Long -Term Debt to Equity Capital (also called
Debt to Equity)
Capital Structure and Solvency
Adjustments of Long-Term Debt to Equity--See Appendix 11C
equ i t y s har eho l der
debt t er m-Long
S
Capital Structure Measures
Capital Structure and Solvency
Capital Structure Measures
T o t a l D e b t t o E q u i t y
0, 0 0, 2 0, 4 0, 6 0, 8 1, 0
Food store s
Ea ting an d dr ink ing
Moti on p ictu re s
Pri ntin g a nd p ubli shi ng
Ele ctri cal e quip m e nt
Edu cat iona l se rv ice s
Ge ne ral m e rch and ise
R a t i o
Source,Dun & Bradstreet
Short-Term Debt to Total Debt
Equity Capital at Market Value
Capital Structure and Solvency
Capital Structure Measures
Common-size and ratio analyses of capital structure mainly reflect
capital structure risk
Capital structure measures serve as screening devices
Extended analysis focuses financial condition,results of
operations,and future prospects
Prior to long-term solvency analysis,we perform liquidity analysis
to be satisfied about near-term survival
Additional analyses include examination of
? Debt maturities (amount and timing)
? Interest costs
? Risk-bearing factors (earnings persistence,industry
performance,and asset composition)
Capital Structure and Solvency
Interpretation of Capital Structure Measures
Asset Composition Analysis
Tool in assessing the risk exposure of a capital structure
Typically evaluated using common-size statements
Capital Structure and Solvency
Asset-Based Measures of Solvency
Asset Coverage
? Assets provide protection to creditors--earning power
and liquidation value
? Base for additional financing
? Useful ratios include,
? Fixed assets to equity capital
? Net tangible assets to long-term debt
? Total liabilities to net tangible assets
Capital Structure and Solvency
Asset-Based Measures of Solvency
Earning Coverage
Earnings to Fixed Charges
Earnings to fixed charges ratio
c ha r ge s " F i x e d"
c ha r ge s " f i x ed f o r a v a i l ab l e E a r n i n g s"
Additional Liquidity Measures
Earnings to Fixed Charges
(a) Pre-tax income before discontinued operations,extraordinary items,and cumulative effects of accounting changes,
(b) Interest incurred less interest capitalized,
(c) Usually included in interest expense,
(d) Financing leases are capitalized so the interest implicit in these is already included in interest expense,However,the interest portion of long-term
operating leases is included on the assumption many long-term operating leases narrowly miss the capital lease criteria,but have many
characteristics of a financing transaction,
(e) Excludes all items eliminated in consolidation,The dividend amount is increased to pre-tax earnings required to pay for it,Computed as [Preferred
stock dividend requirements]/[1 Income tax rate],The income tax rate is computed as [Actual income tax provision]/[Income before income taxes,
extraordinary items,and cumulative effect of accounting changes],
(f) Applies to nonutility companies,This amount is not often disclosed,
(g) Minority interest in income of majority-owned subsidiaries having fixed charges can be included in income,
(h) Included whether expensed or capitalized,
For ease of presentation,two items (provisions) are left out of the ratio above,
1,Losses of majority-owned subsidiaries should be considered in full when computing earnings,
2,Losses on investments in less than 50-percent-owned subsidiaries accounted for by the equity method should not be included in earnings
unless the company guarantees subsidiaries’ debts,
?
?
?
?
?
?
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ess u b s i d i a r i o w n e d-m a j o r i t y of tsr e q u i r e m e n d i v i d e n d s t o c k p r e f e r r e d
a d j u s t e d-T a x )( e x p e n s e s r e n t a l o p e r a t i n g of p o r t i o nI n t e r e s t )( p r e m i u m
ord i s c o u n t a n d e x p e n s ed e b t of i o n A m o r t i z a t)( i n c u r r e di n t e r e s t T o t a l )(
a f f i l i a t e s or ess u b s i d i a r i o w n e d-p e r c e n t-50 t h a n l e s s of i n c o m e t e dU n d i s t r i b u )( p e r i o d t h e in a m o r t i ze d
i n t e r e s t dc a p i t a l i ze p r e v i o u s l y of A m o u n t )( ess u b s i d i a r i o w n e d-m a j o r i t y of
tsr e q u i r e m e n d i v i d e n d s t o c k p r e f e r r e d a d j u s t e d-T a x )( e x p e n s e s r e n t a l o p e r a t i n g of
p o r t i o nI n t e r e s t )( p r e m i u m ord i s c o u n t a n d e x p e n s ed e b t of i o n A m o r t i z a t)(
e x p e n s eI n t e r e s t )( o p e r a t i o n s c o n t i n u i n g f r o m i n c o m e t a x-P r e )(
ep l u sdp l u s
cp l u sh
gmi n u s
fp l u s
ep l u s
dp l u sc
p l u sbp l u sa
Earning Coverage
Earnings to Fixed Charges - Illustration
C O M PU TECH CO R PO R A TIO N
I nc om e St a t e m e nt
N e t s a l e s $ 1 3,4 0 0,0 0 0
I nc om e of l e s s t ha n 5 0 % - owne d a f f i l i a t e s ( a l l [ nb] undi s t ri but e d) 6 0 0,0 0 0
Tot a l re v e nue $ 1 4,0 0 0,0 0 0
C os t of goods s ol d $ 7,4 0 0,0 0 0
Sel l i ng,ge ne ra l,a nd a dm i ni s t ra t i v e e x pe ns e s 1,9 0 0,0 0 0
D e pre c i a t i on ( e x c l ude d f rom a bov e c os t s ) 3 8 0 0,0 0 0
I nt e re s t e x pe ns e 1 —ne t 7 0 0,0 0 0
R e nt a l e x pe ns e 2 8 0 0,0 0 0
Sh a re of m i nori t y i nt e re s t s i n c ons ol i da t e d i nc om e 4 2 0 0,0 0 0 1 1,8 0 0,0 0 0
I nc om e be f ore t a x e s $ 2,2 0 0,0 0 0
I nc om e t a x e s,
C urre nt $ 8 0 0,0 0 0
D e f e rre d 3 0 0,0 0 0 ( 1,1 0 0,0 0 0 )
I nc om e be f ore e x t ra ordi na ry i t e m $ 1,1 0 0,0 0 0
Ext ra ordi na ry ga i n ( ne t of $ 6 7,0 0 0 t a x ) 2 0 0,0 0 0
N e t i nc om e $ 1,3 0 0,0 0 0
D i v i de nds,
On c om m on s t oc k $ 2 0 0,0 0 0
On pre f e rre d s t oc k 4 0 0,0 0 0 6 0 0,0 0 0
Ear ni ngs re t a i ne d f or t he y e a r $ 7 0 0,0 0 0
S e le ct e d n o te s to t h e f in a n cia l s ta te m e n ts,
1 I n te r e st e xp e n se is c o m p o se d o f th e f o llo wing,
I n te r e st in cu r r e d ( e xc e p t ite m s b e lo w) $ 7 4 0,0 0 0
Am o r tiz a tio n o f b o n d d isco u n t 6 0,0 0 0
I n te r e st p o r tio n o f ca p ita lize d le a se s 1 0 0,0 0 0
I n te r e st c a p ita lize d ( 2 0 0,0 0 0 )
I n te r e st e xp e n se $ 7 0 0,0 0 0
2 I n te r e st im p licit in n o n ca p ita lize d le a se s a m o u n ts t o $ 3 0 0,0 0 0,
3 De p r e cia tio n in clu d e s a m o r tiz a tio n o f p r e vio u sly ca p ita lize d in te r e st o f $ 8 0,0 0 0,
4 T h e se s u b sid ia r ie s h a ve f ixe d c h a r g e s.
A d d itio n a l in fo r m a tio n ( d u r in g t h e in co m e s ta te m e n t p e r io d ),
I n cr e a se in a cc o u n ts r e ce iva b le $ 3 1 0,0 0 0
I n cr e a se in in ve n to r ie s 1 8 0,0 0 0
I n cr e a se in a cc o u n ts p a ya b le 1 4 0,0 0 0
D e c r e a s e i n a c c r u e d t a x e s 2 0,0 0 0
Ear n in g s t o f ix e d c h a r g e s r a t io,
$2,( ) $ 7 0 0200
2 40
a b c d f g
h c d
? ? ? ? ?
? ?
?
( ) $ 3 0 0 ( ) $ 8 0 ( ) $ 6 0 0 ( ) $ 2 0 0
$ 8 4 0 ( ) $ 6 0 ( ) $ 3 0 0 ( )
.
*
a n d
* N o t e, Th e SE C p e r mi t s in c lu d in g in in c o me t h e mi n o r it y in t e r e s t in t h e in c o me o f ma jo r it y - o w n e d s u b s id ia r ie s h a v in g f ix e d
c h a r g e s, Th is a mo u n t is a d d e d t o r e v e r s e a s im ila r d e d u c t io n f r o m in c o me,
Earning Coverage
Tiimes Interest Earned
Times interest earned ratio
ex pe n s e I n t er es t
ex pe n s e I n t er es t+ex pe n s eT a x +I n c om e
Earning Coverage
Cash Flow to Fixed Charges
Cash Flow to Fixed Charges Ratio
c ha r ge s F
( g)–( b) sA d j us t m en t+f l o w c as h o pe r at i ngt ax -P r e
i x e d
Earning Coverage
Cash Flow to Fixed Charges - Illustration
Fixed charges needing to be added back to CampuTech’s pre-tax cash from
operations,
Pre-tax cash from operations $ 2,290,000
Interest expensed(less bond discount added back above) 640,000
Interest portion of operating rental expense 300,000
Amount of previously capitalized interest amortized during period* -
Total numerator $ 3,230,000
*Assume included in depreciation (already added back),
Fixed charges for the ratio’s denominator are,
Interest incurred $ 900,000
Interest portion of operating rentals 300,000
Fixed charges $ 1,200,000
CompuTech’s cash flow to fixed charges ratio is,
6920 0 02 0 01 0 0 02 3 03,,,$,,$ ?
Earning Coverage
Earnings Coverage of Preferred Dividends
Earnings coverage of preferred dividends
ratio,
?
?
??
?
?
?
?
r a t e
d i v i d e n d s P r e f e r r e d+c h a r g e s F
( g )( b ) A d j u s t e d+i n c o m et a x -P r e
T a x
i x e d
1
Earning Coverage
Interpreting 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
Earning Coverage
Capital Structure Risk and Return
? 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
Return
$
Risk
Criteria determining a specific rating involve both
quantitative and qualitative factors
? Asset protection
? Financial resources
? Earning power
? Management
? Debt provisions
? Other,Company size,market share,industry position,
cyclical influences,and economic conditions
Rating Debt Obligations— Appendix 11A
Rating Criteria
Rating Criteria
Rating Debt Obligations— Appendix 11A
T r e a s u r y a n d C o m p a n y B o n d Y i e l d R a t e s ( O n e - Y e a r
M a t u r i t y )
0, 0 2, 0 4, 0 6, 0 8, 0 1 0, 0
Tre asu ry
AAA
AA
A
BBB
BB+
BB/BB-
R a t i o
Source,Standard & Poor’s,December 1996,
Bond Quality Ratings
Rating Grades Standard & Poor’s Moody’s
Highest grade AAA Aaa
High grade AA Aa
Upper medium A A
Lower medium BBB Baa
Marginally speculative BB Ba
Highly speculative B B,Caa
Default D Ca,C
Rating Criteria
Rating Debt Obligations— Appendix 11A
X1 = Working capital/Total assets
X2 = Retained earnings/Total assets
X3 = Earnings before interest and taxes/Total assets
X4 = Shareholders’ equity/Total liabilities
X5 = Sales/Total assets
Z<1.20 implies a high probability of bankruptcy
Z>2.90 implies a low probability of bankruptcy
1.20<Z<2.90 implies an ambiguous area
Predicting Financial Distress— Appendix 11B
Altman Z-Score
54321 9 9 8.04 2 0.01 0 7.38 4 7.07 1 7.0 XXXXXZ ?????
LTD = Long-term debt consisting of all long-term liabilities inclusive of
(1) noncurrent deferred taxes likely to reverse,and (2) other
noncurrent liabilities,
NFL = Estimated present value of noncapitalized financial leases,
SE = Shareholders’ equity,including minority interests,
NDT = Noncurrent deferred taxes assessed as unlikely to reverse in the
foreseeable future,
LR = LIFO reserve (excess of disclosed FIFO value of
ending inventory over reported LIFO amount),
MSA = Excess of market value of marketable securities
over cost (for analysis of financial statements
prior to 1994),
Analytical Adjustments to Long-Term Debt
to Equity Ratio— Appendix 11C
Ratio Adjustment
M S ALRN D TSE
N F LDLT
???
?
CHAPTER
Credit Analysis
Company Liquidity refers to the ability to meet short-
term obligations
Liquidity is the ability to convert
assets into cash or to
obtain cash
Short term is the longer of one-year
or the company operating cycle
Liquidity and Working Capital
Basics
Liquidity is a matter of degree
Lack of liquidity can limit
? Advantages of favorable discounts
? Profitable opportunities
? Management actions
? Coverage of current obligations
Liquidity and Working Capital
Basics
Severe illiquidity often precedes
? Lower profitability
? Restricted opportunities
? Loss of owner control
? Loss of capital investment
? Insolvency and bankruptcy
Liquidity and Working Capital
Basics
Current assets are 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 company’s operating cycle
Current assets include,
Cash -- ultimate liquid asset
Cash equivalents -- temporary investments of excess cash
Marketable securities -- debt or equity securities held as s-t investments
Accounts receivable -- mounts due from credit sales
Inventories -- items held for sale in the normal course of business
Prepaid expenses -- advance payments for services and supplies
Liquidity and Working Capital
Current Assets
Classification as current asset
depends on,
1,Manament’s intent
2,Industry practice
Analysis must assess this classification
1,Is classification as current asset appropriate?
2,If not,then adjust accounts and amounts among current
and noncurrent
Liquidity and Working Capital
Current Assets
Balance
Sheet
Classification as current liability depends on,
1,Manament’s intent
2,Industry practice
Analysis must assess this classification
1,Is classification as current liability appropriate?
2,If not,then adjust accounts and amounts among current and noncurrent
3,Are current liabilities reported?
4,If not,then adjust accounts for these amounts—potential examples,
? Contingent liabilities associated with loan guarantees
? Future minimum rental payments under noncancelable operating leases
? Progress payments under contracts
? Current deferred tax liabilities (and assets)
Liquidity and Working Capital
Current Liabilities
Working capital is
? defined as the excess of current assets over current liabilities
? Widely used measure of short-term liquidity
? Deficient when current liabilities exceed current assets
? In surplus when current assets exceed current liabilities
? A margin of safety for creditors
? A liquid reserve to meet contingencies and uncertainties
? A constraint for technical default in many debt agreements
Liquidity and Working Capital
Working Capital
Working capital more relevant when related to other key
variables such as
? Sales
? Total assets
Working capital is of limited value as an absolute
amount
Liquidity and Working Capital
Working Capital
Current Ratio Reflects on,
? Current liability coverage -- assurance in covering current
liabilities
? Buffer against losses -- margin of safety for shrinkage in
noncash current assets
? Reserve of liquid funds --margin of safety
against uncertainties and shocks to cash flows
Liquidity and Working Capital
Current Ratio
sl i a b i l i t i e C u r r e n t
a s s e t s C u r r e n t=r a t i o C u r r e n t
Current Ratio — Limitations,
If liquidity is the ability to meet cash outflows with adequate
cash inflows,then does the current ratio,
? Measure and predict the pattern of future cash inflows and
outflows?
? Measure the adequacy of future cash inflows to outflows?
Answer is generally no to both these questions
Current ratio
? Is a static measure
? Does not have a causal relation to future
cash inflows
Liquidity and Working Capital
Current Ratio
Current Ratio — Limitations in Numerator
Adjustments often needed to counter various 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
Liquidity and Working Capital
Current Ratio
Three important qualifications
1,Liquidity depends to a large extent on prospective cash
flows
2,No direct relation between working capital account
balances and patterns of future cash flows
3,Managerial policies are directed primarily at efficient and
profitable asset utilization and secondly at liquidity
4,Cash flow forecasts and pro forma financial statements
are preferred over the current ratio for liquidity and
solvency analysis
5,Current ratio is a static measure of the ability of current
assets to satisfy current liabilities
Liquidity and Working Capital
Current Ratio
Two important elements are integral to use of the current
ratio
1,Quality of both current assets and current liabilities
2,Turnover rate of both current assets and current
liabilities
Liquidity and Working Capital
Current Ratio
Comparative Analysis
Two useful tools in analyzing
the trend in the current ratio
Trend analysis -- components of working capital and the
current ratio are converted to indexes and examined over
time
Common-size analysis -- composition of current assets is
examined over time
Liquidity and Working Capital
Current Ratio - Applications
Ratio Management (window dressing)
Examples are,
? Press the collection of
receivables at year-end
? Call in advances to officers for
temporary repayment
? Reduce inventory below normal
levels
? Delay normal purchases
Proceeds from these activities are then
used to pay off current liabilities
Liquidity and Working Capital
Current Ratio - Applications
Rule of Thumb Analysis (2:1)
> 2:1 ? superior coverage of current liabilities (but not
too high,suggesting inefficient use of resources
and reduced returns)
< 2:1 ? deficient coverage of current liabilities
Liquidity and Working Capital
Current Ratio - Applications
Net Trade Cycle Analysis
Working capital requirements are affected by its desired
inventory investment and the relation between credit
terms from suppliers and those extended to customers
Liquidity and Working Capital
Current Ratio - Applications
Net Trade Cycle— Illustration
Selected financial information from Technology Resources,Inc.,for the end of Year 1 is
reproduced below,
Sales for Year 1 $360,000
Receivables 40,000
Inventories* 50,000
Accounts payable? 20,000
Cost of goods sold
(including depreciation of $30,000) 320,000
*Beginning inventory is $100,000,
?We assume these relate to purchases included in cost of goods sold,
We estimate Technology Resources’ purchases per day as,
Purchases per day = $240,000 ÷ 360 = $666.67
The net trade cycle for Technology Resources is computed as (in days),
Liquidity and Working Capital
d a y s 6 6, 2 4=( d a y s ) c y c l e t r a d e N e t
d a y s 3 0, 0 0=
$ 6 6 6, 6 7
$ 2 0,0 0 0
=p a y a b l e A c c o u n t s:L e s s
d a y s 9 6, 2 4
d a y s 5 6, 2 4=
360$ 3 2 0,0 0 0
$ 5 0,0 0 0
=sI n v e n t o r i e
d a y s 4 0, 0 0=
360$ 3 6 0,0 0 0
$ 4 0,0 0 0
=r e c e i v a b l e A c c o u n t s
?
?
Current Ratio - Applications
Sales Trend Analysis
Trend analysis — review of sales trend across time
Liquidity and Working Capital
Current Ratio - Applications
Cash to Current Assets Ratio
Larger the ratio,the more liquid are current assets
Liquidity and Working Capital
Cash-Based Ratio of Liquidity
a s s e t s C u r r e n t
s e c u r i ti e s M a r k e t a b l e+se q u i v a l e n t C a s h+C a s h
Cash to Current Liabilities Ratio
Larger the ratio,the more cash available to pay current
obligations
Liquidity and Working Capital
sl i a b i l i ti e C u r r e n t
s e c u r i ti e s M a r k e t a b l e+se q u i v a l e n t C a s h+C a s h
Cash-Based Ratio of Liquidity
Accounts Receivable Turnover
Operating Activity Analysis of Liquidity
Accounts Receivable Liquidity
r ec ei v ab le ac c ou nts A v er ag e
c r edi t on s al es N et
Operating Activity Analysis of Liquidity
Accounts Receivable Liquidity
R e c e i v a b l e s T u r n o v e r f o r S e l e c t e d I n d u s t r i e s
0 20 40 60 80 100 120 140
F o o d s t o re s
Ea t i n g a n d d ri n k i n g
M o t i o n p i c t u re s
Pri n t i n g a n d p u b l i s h i n g
El e c t ri c a l e q u i p m e n t
Ed u c a t i o n a l s e rv i c e s
G e n e ra l m e rc h a n d i s e
R e c e i v a b l e s tu r n o v e r
Source,Dun & Bradstreet
Accounts Receivable Collection Period
Operating Activity Analysis of Liquidity
Accounts Receivable Liquidity
t u r n o v e r r e c e i v a b l e A c c o u n t s
3 6 0=p e r i o d C o l l e c t i o n
Days’ Sales in Receivables (Alternative to Collection Period)
Operating Activity Analysis of Liquidity
Accounts Receivable Liquidity
360
S a l e s R e c e i v a b l e A c c o u n t ?
Temporal Trend Analysis
Trend in,
1,Collection period over time
2,
Operating Activity Analysis of Liquidity
Accounts Receivable Liquidity
r e c e i v a b l e a c c o u n t s G r o s s
a c c o u n t s d o u b t f u l f o r P r o v i s i o n
Inventory Turnover
Measures the average rate of speed inventories move
through and out of a company
Operating Activity Analysis of Liquidity
Inventory Turnover
inv en tor y A v er ag e
s ol d goods of C os t
Days to Sell Inventory
Useful in assessing purchasing and production policies—shows the number of
days a company takes in selling average inventory for that year
Alternative computation-- Days’ Sales in Inventory
where the cost of average day’s sales is,
Shows the number of days required to sell ending inventory
Operating Activity Analysis of Liquidity
Inventory Turnover
tu r no v erIn v en to r y
36 0
s al es sday ' av er age of C os t
inv entor y E ndi ng
360
s o l d goods of C o s t
Selected financial information from Macon Resources,Inc.,for the end of
Year 8 is reproduced below,
Sales $1,800,000
Cost of goods sold 1,200,000
Beginning inventory 200,000
Ending inventory 400,000
Inventory turnover ratios using average inventory are computed as,
Inventory turnover ratios based on ending inventory equal,
Operating Activity Analysis of Liquidity
Inventory Turnover - Illustration
day sD ay s
I nv e nt or y
90
4
2)000,400$000,200($
?
?
?
?
4
3 6 0=r a t i oi n v e n t o r y se l l to
$ 1,2 0 0,0 0 0=r a t i o t u r n o v e r
da y s
$ 3,3 3 3
$ 4 0 0,0 0 0=i n v e n t o r y in sa l e s D a y s'
$ 1,2 0 0,0 0 0=sa l e s sd a y ' a v e r a g e of C o st
120
333,3$
360
?
?
Conversion Period (Operating Cycle),
Days’ to Sell Inventory + Collection Period
Measure of the speed with which inventory is converted
to cash
Operating Activity Analysis of Liquidity
Inventory Turnover
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
Operating Activity Analysis of Liquidity
Liquidity of Current Liabilities
Days’ Purchases in Accounts Payable
Measures the extent accounts payable represent current
and not overdue obligations
Operating Activity Analysis of Liquidity
Inventory Turnover
3 6 0P u r c h a s e s
p a y a b l e A c c o u n t s=p a y a b l e a c c o u n t s in p u r c h a s e s Days’ ?
Additional Liquidity Measures
Asset Composition
Composition of current
assets is an indicator of
working capital liquidity
Use of common-size
percentage comparisons
facilitates this analysis
Balance
Sheet
Liquidity Index
Expressed in days and its computation is a weighting
mechanism
Analysis of Index must involve comparative analyses,
? Measure of period-to-period change in liquidity
? Measure of relative liquidity across companies
Increases signify a deterioration in liquidity
Decreases signify improved liquidity
Additional Liquidity Measures
Liquidity Index - Illustration
Using the financial data of Texas Electric,we find their
conversion of inventories into accounts receivable takes 50
days (on average) and their conversion of receivables into
cash takes 40 days (on average),The liquidity index for
Texas Electric is computed as,
Year 1,
Amount x Days Removed = Product
from Cash Dollar x Days
Cash $ 30,000 — —
Accounts receivable 40,000 40 days 1,600,000
Inventories 30,000 90 days 2,700,000
Total $100,000 (a) 4,300,000 (b)
d a y s 43=
$ 1 0 0,0 0 0
4,3 0 0,0 0 0==i n d e x
a
b
L iq u id it y
Additional Liquidity Measures
Acid-Test (Quick) Ratio
sl i a b i l i t i e C u r r e n t
r e c e i v a b l e A c c o u n t s+s e c u r i t i e s M a r k e t a b l e+se q u i v a l e n t C a s h+C a s h
Is a more stringent test of liquidity
vis-à-vis current ratio
Additional Liquidity Measures
D u n & B r ad str ee t' s Qu i ck R ati o fo r Sel ec ted
I n d u str i es
0 0, 3 0, 6 0, 9 1, 2 1, 5
Food store s
Ea ting an d dr ink ing
Moti on p ictu re s
Pri ntin g a nd p ubli shi ng
Ele ctri cal e quip m e nt
Edu cat iona l se rv ice s
Ge ne ral m e rch and ise
R a t i o
Acid-Test (Quick) Ratio
Additional Liquidity Measures
Source,Dun & Bradstreet
(Cash + Account Receivables/Current Liabilities)
Cash Flow Measures
Cash Flow Ratio
A ratio of 0.40 or higher is common for
healthy companies
sl i a b i l i t i e C u r r e n t
f l o w c a s h O p e r a t i n g
Additional Liquidity Measures
Financial Flexibility
Financial flexibility - ability of a company to take steps
to counter unexpected interruptions in the flow of funds
Focus of analysis,
? 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
Additional Liquidity Measures
Management’s Discussion and Analysis
MD&A requires a discussion of liquidity — including
? Known trends
? Demands
? Commitments
? Uncertainties
? Ability to generate cash
? Internal and external sources of liquidity
? Any material unused sources of liquid assets
Additional Liquidity Measures
Additional Liquidity Measures
What-If Analysis
What-if analysis -- technique to trace through the
effects of changes in conditions or policies on the
cash resources of a company
What-If Analysis - Illustration
Background Data—Consolidated Technologies at December 31,Year 1,
Cash $ 70,000
Accounts receivable 150,000
Inventory 65,000 Accounts payable 130,000
Notes payable 35,000
Accrued taxes 18,000
Fixed assets 200,000
Accumulated depreciation 43,000
Capital stock 200,000
The following additional information is reported for Year 1,
Sales $750,000
Cost of sales 520,000
Purchases 350,000
Depreciation 25,000
Net 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
Additional Liquidity Measures
What-If Analysis - Illustration
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 $ 70,000
Cash 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 $ 838,750
Cash 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) 203,500 749,500
Cash,December 31,Year 2 $ 89,250
Cash balance desired 50,000
Cash excess $ 39,250
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),
Additional Liquidity Measures
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
Basic of Solvency
Facts
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
Basic of Solvency
Capital Structure
From a shareholder’s perspective,debt financing is less
expensive than equity financing because,
1.Financial Leverage--Interest on most
debt is fixed,and provided interest is
less than the return earned from debt
financing,the excess return goes to
equity investors
2.Tax Deductibility of Interest--Interest is
a tax-deductible expense whereas
dividends are not
Basic of Solvency
Motivation for Debt
Leverage -- use of debt to increase net income
Leverage,
? Magnifies both managerial success (profits) and failure
(losses)
? Increases risks
? Limits flexibility in pursuing opportunities
? Decreases creditors’ protection against loss
Companies with leverage are said to be trading on the equity
— omplying a company is using equity financing to obtain debt
financing in a desire to reap returns above the cost of debt,
Basic of Solvency
Financial Leverage
Trading on the Equity—Returns for Different Earnings Levels ($ thousands)
Financing Sources Return on
Income before
Interest and 10 Percent Net Net Income + [Interest
Assets Debt Equity Taxes Debt Interest Taxes* Income (1 - Tax Rate)] Assets? Equity?
Year 1,
Risky,Inc,$1,000,000 $400,000 $600,000 $200,000 $40,000 $64,000 $96,000 $120,000 12.0% 16.0%
Safety,Inc,1,000,000 1,000,000 200,000 80,000 120,000 120,000 12.0 12.0
Year 2,
Risky,Inc,1,000,000 400,000 600,000 100,000 40,000 24,000 36,000 60,000 6.0 6.0
Safety,Inc,1,000,000 1,000,000 100,000 40,000 60,000 60,000 6.0 6.0
Year 3,
Risky,Inc,1,000,000 400,000 600,000 50,000 40,000 4,000 6,000 30,000 3.0 1.0
Safety,Inc,1,000,000 1,000,000 50,000 20,000 30,000 30,000 3.0 3.0
* Tax rate is 40 percent,
? Return on assets = Net income + Interest (1 – 0.40)/Assets,
? Return on equity = Net income/Shareholders’ equity,
Basic of Solvency
Financial Leverage - Illustration
Consider two companies’ results for Year 2,
Year 2 Financials Risky,Inc,Safety,Inc,
Income before interest and taxes $ 100,000 $ 100,000
Interest (10% of $400,000) 40,000 —
Income before taxes $ 60,000 $ 100,000
Taxes (40%) 24,000 40,000
Net income $ 36,000 $ 60,000
Add back interest paid to bondholder 40,000 —
Total return to security holders
(debt and equity) $ 76,000 60,000
Basic of Solvency
Financial Leverage- Illustrating Tax Deductibility
of Interest
Financial Leverage Index
> 1.0 ? favorable effects from leverage
< 1.0 ? unfavorable effects from leverage
= 1.0 ? neutral effects from leverage
Basic of Solvency
Financial Leverage
a s s e t s on R e t u r n
e q u i t y c o m m o n on R e t u r n
Basic of Solvency
Financial Leverage
F i n a n c i a l L e v e r a g e I n d e x
0, 0 0, 5 1, 0 1, 5 2, 0 2, 5
Food store s
Ea ting an d dr ink ing
Moti on p ictu re s
Pri ntin g a nd p ubli shi ng
Ele ctri cal e quip m e nt
Edu cat iona l se rv ice s
Ge ne ral m e rch and ise
I n d e x
Source,Dun & Bradstreet
F i n a n c i a l L e v e r a g e R a t i o
0, 0 0, 5 1, 0 1, 5 2, 0 2, 5
Food store s
Ea ting an d dr ink ing
Moti on p ictu re s
Pri ntin g a nd p ubli shi ng
Ele ctri cal e quip m e nt
Edu cat iona l se rv ice s
Ge ne ral m e rch and ise
R a t i o
Basic of Solvency
Financial Leverage
Source,Dun & Bradstreet
Financial Leverage Ratio
Greater the proportion of financing from equity vs,debt
? lower the financial leverage ratio
Note,Financial leverage ratio is a component
of the disaggregated return on equity
— see Chapter 8
Basic of Solvency
Financial Leverage
c api t alequi t y C om m on
as s et s T ot al
Potential accounts needing adjustments Chapter reference
Deferred Income Taxes — Is it a liability,3 & 6
equity,or some of both?
Operating Leases -- capitalize non- 3
cancelable operating leases?
Off-Balance-Sheet Financing 3
Pensions and Postretirement Benefits 3
Unconsolidated Subsidiaries 5
Contingent Liabilities 3 & 6
Minority Interests 5
Convertible Debt 3
Preferred Stock 3
Basic of Solvency
Adjustments for Capital Structure - Liabilities
Balance
Sheet
Potential accounts needing adjustments Chapter reference
Inventories—LIFO Reserve? 4
Marketable Securities 4
Intangible Assets 4 & 5
Basic of Solvency
Adjustments for Capital Structure - Assets
Balance
Sheet
Projection of Future Cash Inflows and Outflows
Reflects on risk for a levered company’s capital structure
Prepare a Statement of Forecasts of Cash Inflows and
Outflows
Capital Structure and Solvency
Long-Term Projections
Chapter 10 described and illustrated long-term cash flow forecasts
Capital structure composition analysis
? Performed by constructing a common -
size statement of liabilities and equity
? Reveals relative magnitude of financing sources
? Allows direct comparisons across different
companies
? Two Variations—(1) Use ratios,and (2) Exclude current
liabilities
Capital Structure and Solvency
Common-Size Statements
Total Debt to Total Capital (also called total debt ratio)
Capital Structure and Solvency
Capital Structure Measures
c a p i ta l
d e b t T o ta l
T o ta l
Capital Structure and Solvency
Capital Structure Measures
L o n g - T e r m D e b t t o E q u i t y R a t i o
0, 0 0, 1 0, 2 0, 3 0, 4 0, 5
Food store s
Ea ting an d dr ink ing
Moti on p ictu re s
Pri ntin g a nd p ubli shi ng
Ele ctri cal e quip m e nt
Edu cat iona l se rv ice s
Ge ne ral m e rch and ise
R a t i o
Source,Dun & Bradstreet
Total Debt to Equity Capital
Reciprocal measure of this ratio—Equity Capital to
Total Debt
Capital Structure and Solvency
Capital Structure Measures
equ i t y s har eho l der
debt T ot al
S
debt T o t a l
e q u i t y s h a r e h o l d e rS
Long -Term Debt to Equity Capital (also called
Debt to Equity)
Capital Structure and Solvency
Adjustments of Long-Term Debt to Equity--See Appendix 11C
equ i t y s har eho l der
debt t er m-Long
S
Capital Structure Measures
Capital Structure and Solvency
Capital Structure Measures
T o t a l D e b t t o E q u i t y
0, 0 0, 2 0, 4 0, 6 0, 8 1, 0
Food store s
Ea ting an d dr ink ing
Moti on p ictu re s
Pri ntin g a nd p ubli shi ng
Ele ctri cal e quip m e nt
Edu cat iona l se rv ice s
Ge ne ral m e rch and ise
R a t i o
Source,Dun & Bradstreet
Short-Term Debt to Total Debt
Equity Capital at Market Value
Capital Structure and Solvency
Capital Structure Measures
Common-size and ratio analyses of capital structure mainly reflect
capital structure risk
Capital structure measures serve as screening devices
Extended analysis focuses financial condition,results of
operations,and future prospects
Prior to long-term solvency analysis,we perform liquidity analysis
to be satisfied about near-term survival
Additional analyses include examination of
? Debt maturities (amount and timing)
? Interest costs
? Risk-bearing factors (earnings persistence,industry
performance,and asset composition)
Capital Structure and Solvency
Interpretation of Capital Structure Measures
Asset Composition Analysis
Tool in assessing the risk exposure of a capital structure
Typically evaluated using common-size statements
Capital Structure and Solvency
Asset-Based Measures of Solvency
Asset Coverage
? Assets provide protection to creditors--earning power
and liquidation value
? Base for additional financing
? Useful ratios include,
? Fixed assets to equity capital
? Net tangible assets to long-term debt
? Total liabilities to net tangible assets
Capital Structure and Solvency
Asset-Based Measures of Solvency
Earning Coverage
Earnings to Fixed Charges
Earnings to fixed charges ratio
c ha r ge s " F i x e d"
c ha r ge s " f i x ed f o r a v a i l ab l e E a r n i n g s"
Additional Liquidity Measures
Earnings to Fixed Charges
(a) Pre-tax income before discontinued operations,extraordinary items,and cumulative effects of accounting changes,
(b) Interest incurred less interest capitalized,
(c) Usually included in interest expense,
(d) Financing leases are capitalized so the interest implicit in these is already included in interest expense,However,the interest portion of long-term
operating leases is included on the assumption many long-term operating leases narrowly miss the capital lease criteria,but have many
characteristics of a financing transaction,
(e) Excludes all items eliminated in consolidation,The dividend amount is increased to pre-tax earnings required to pay for it,Computed as [Preferred
stock dividend requirements]/[1 Income tax rate],The income tax rate is computed as [Actual income tax provision]/[Income before income taxes,
extraordinary items,and cumulative effect of accounting changes],
(f) Applies to nonutility companies,This amount is not often disclosed,
(g) Minority interest in income of majority-owned subsidiaries having fixed charges can be included in income,
(h) Included whether expensed or capitalized,
For ease of presentation,two items (provisions) are left out of the ratio above,
1,Losses of majority-owned subsidiaries should be considered in full when computing earnings,
2,Losses on investments in less than 50-percent-owned subsidiaries accounted for by the equity method should not be included in earnings
unless the company guarantees subsidiaries’ debts,
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
?
ess u b s i d i a r i o w n e d-m a j o r i t y of tsr e q u i r e m e n d i v i d e n d s t o c k p r e f e r r e d
a d j u s t e d-T a x )( e x p e n s e s r e n t a l o p e r a t i n g of p o r t i o nI n t e r e s t )( p r e m i u m
ord i s c o u n t a n d e x p e n s ed e b t of i o n A m o r t i z a t)( i n c u r r e di n t e r e s t T o t a l )(
a f f i l i a t e s or ess u b s i d i a r i o w n e d-p e r c e n t-50 t h a n l e s s of i n c o m e t e dU n d i s t r i b u )( p e r i o d t h e in a m o r t i ze d
i n t e r e s t dc a p i t a l i ze p r e v i o u s l y of A m o u n t )( ess u b s i d i a r i o w n e d-m a j o r i t y of
tsr e q u i r e m e n d i v i d e n d s t o c k p r e f e r r e d a d j u s t e d-T a x )( e x p e n s e s r e n t a l o p e r a t i n g of
p o r t i o nI n t e r e s t )( p r e m i u m ord i s c o u n t a n d e x p e n s ed e b t of i o n A m o r t i z a t)(
e x p e n s eI n t e r e s t )( o p e r a t i o n s c o n t i n u i n g f r o m i n c o m e t a x-P r e )(
ep l u sdp l u s
cp l u sh
gmi n u s
fp l u s
ep l u s
dp l u sc
p l u sbp l u sa
Earning Coverage
Earnings to Fixed Charges - Illustration
C O M PU TECH CO R PO R A TIO N
I nc om e St a t e m e nt
N e t s a l e s $ 1 3,4 0 0,0 0 0
I nc om e of l e s s t ha n 5 0 % - owne d a f f i l i a t e s ( a l l [ nb] undi s t ri but e d) 6 0 0,0 0 0
Tot a l re v e nue $ 1 4,0 0 0,0 0 0
C os t of goods s ol d $ 7,4 0 0,0 0 0
Sel l i ng,ge ne ra l,a nd a dm i ni s t ra t i v e e x pe ns e s 1,9 0 0,0 0 0
D e pre c i a t i on ( e x c l ude d f rom a bov e c os t s ) 3 8 0 0,0 0 0
I nt e re s t e x pe ns e 1 —ne t 7 0 0,0 0 0
R e nt a l e x pe ns e 2 8 0 0,0 0 0
Sh a re of m i nori t y i nt e re s t s i n c ons ol i da t e d i nc om e 4 2 0 0,0 0 0 1 1,8 0 0,0 0 0
I nc om e be f ore t a x e s $ 2,2 0 0,0 0 0
I nc om e t a x e s,
C urre nt $ 8 0 0,0 0 0
D e f e rre d 3 0 0,0 0 0 ( 1,1 0 0,0 0 0 )
I nc om e be f ore e x t ra ordi na ry i t e m $ 1,1 0 0,0 0 0
Ext ra ordi na ry ga i n ( ne t of $ 6 7,0 0 0 t a x ) 2 0 0,0 0 0
N e t i nc om e $ 1,3 0 0,0 0 0
D i v i de nds,
On c om m on s t oc k $ 2 0 0,0 0 0
On pre f e rre d s t oc k 4 0 0,0 0 0 6 0 0,0 0 0
Ear ni ngs re t a i ne d f or t he y e a r $ 7 0 0,0 0 0
S e le ct e d n o te s to t h e f in a n cia l s ta te m e n ts,
1 I n te r e st e xp e n se is c o m p o se d o f th e f o llo wing,
I n te r e st in cu r r e d ( e xc e p t ite m s b e lo w) $ 7 4 0,0 0 0
Am o r tiz a tio n o f b o n d d isco u n t 6 0,0 0 0
I n te r e st p o r tio n o f ca p ita lize d le a se s 1 0 0,0 0 0
I n te r e st c a p ita lize d ( 2 0 0,0 0 0 )
I n te r e st e xp e n se $ 7 0 0,0 0 0
2 I n te r e st im p licit in n o n ca p ita lize d le a se s a m o u n ts t o $ 3 0 0,0 0 0,
3 De p r e cia tio n in clu d e s a m o r tiz a tio n o f p r e vio u sly ca p ita lize d in te r e st o f $ 8 0,0 0 0,
4 T h e se s u b sid ia r ie s h a ve f ixe d c h a r g e s.
A d d itio n a l in fo r m a tio n ( d u r in g t h e in co m e s ta te m e n t p e r io d ),
I n cr e a se in a cc o u n ts r e ce iva b le $ 3 1 0,0 0 0
I n cr e a se in in ve n to r ie s 1 8 0,0 0 0
I n cr e a se in a cc o u n ts p a ya b le 1 4 0,0 0 0
D e c r e a s e i n a c c r u e d t a x e s 2 0,0 0 0
Ear n in g s t o f ix e d c h a r g e s r a t io,
$2,( ) $ 7 0 0200
2 40
a b c d f g
h c d
? ? ? ? ?
? ?
?
( ) $ 3 0 0 ( ) $ 8 0 ( ) $ 6 0 0 ( ) $ 2 0 0
$ 8 4 0 ( ) $ 6 0 ( ) $ 3 0 0 ( )
.
*
a n d
* N o t e, Th e SE C p e r mi t s in c lu d in g in in c o me t h e mi n o r it y in t e r e s t in t h e in c o me o f ma jo r it y - o w n e d s u b s id ia r ie s h a v in g f ix e d
c h a r g e s, Th is a mo u n t is a d d e d t o r e v e r s e a s im ila r d e d u c t io n f r o m in c o me,
Earning Coverage
Tiimes Interest Earned
Times interest earned ratio
ex pe n s e I n t er es t
ex pe n s e I n t er es t+ex pe n s eT a x +I n c om e
Earning Coverage
Cash Flow to Fixed Charges
Cash Flow to Fixed Charges Ratio
c ha r ge s F
( g)–( b) sA d j us t m en t+f l o w c as h o pe r at i ngt ax -P r e
i x e d
Earning Coverage
Cash Flow to Fixed Charges - Illustration
Fixed charges needing to be added back to CampuTech’s pre-tax cash from
operations,
Pre-tax cash from operations $ 2,290,000
Interest expensed(less bond discount added back above) 640,000
Interest portion of operating rental expense 300,000
Amount of previously capitalized interest amortized during period* -
Total numerator $ 3,230,000
*Assume included in depreciation (already added back),
Fixed charges for the ratio’s denominator are,
Interest incurred $ 900,000
Interest portion of operating rentals 300,000
Fixed charges $ 1,200,000
CompuTech’s cash flow to fixed charges ratio is,
6920 0 02 0 01 0 0 02 3 03,,,$,,$ ?
Earning Coverage
Earnings Coverage of Preferred Dividends
Earnings coverage of preferred dividends
ratio,
?
?
??
?
?
?
?
r a t e
d i v i d e n d s P r e f e r r e d+c h a r g e s F
( g )( b ) A d j u s t e d+i n c o m et a x -P r e
T a x
i x e d
1
Earning Coverage
Interpreting 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
Earning Coverage
Capital Structure Risk and Return
? 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
Return
$
Risk
Criteria determining a specific rating involve both
quantitative and qualitative factors
? Asset protection
? Financial resources
? Earning power
? Management
? Debt provisions
? Other,Company size,market share,industry position,
cyclical influences,and economic conditions
Rating Debt Obligations— Appendix 11A
Rating Criteria
Rating Criteria
Rating Debt Obligations— Appendix 11A
T r e a s u r y a n d C o m p a n y B o n d Y i e l d R a t e s ( O n e - Y e a r
M a t u r i t y )
0, 0 2, 0 4, 0 6, 0 8, 0 1 0, 0
Tre asu ry
AAA
AA
A
BBB
BB+
BB/BB-
R a t i o
Source,Standard & Poor’s,December 1996,
Bond Quality Ratings
Rating Grades Standard & Poor’s Moody’s
Highest grade AAA Aaa
High grade AA Aa
Upper medium A A
Lower medium BBB Baa
Marginally speculative BB Ba
Highly speculative B B,Caa
Default D Ca,C
Rating Criteria
Rating Debt Obligations— Appendix 11A
X1 = Working capital/Total assets
X2 = Retained earnings/Total assets
X3 = Earnings before interest and taxes/Total assets
X4 = Shareholders’ equity/Total liabilities
X5 = Sales/Total assets
Z<1.20 implies a high probability of bankruptcy
Z>2.90 implies a low probability of bankruptcy
1.20<Z<2.90 implies an ambiguous area
Predicting Financial Distress— Appendix 11B
Altman Z-Score
54321 9 9 8.04 2 0.01 0 7.38 4 7.07 1 7.0 XXXXXZ ?????
LTD = Long-term debt consisting of all long-term liabilities inclusive of
(1) noncurrent deferred taxes likely to reverse,and (2) other
noncurrent liabilities,
NFL = Estimated present value of noncapitalized financial leases,
SE = Shareholders’ equity,including minority interests,
NDT = Noncurrent deferred taxes assessed as unlikely to reverse in the
foreseeable future,
LR = LIFO reserve (excess of disclosed FIFO value of
ending inventory over reported LIFO amount),
MSA = Excess of market value of marketable securities
over cost (for analysis of financial statements
prior to 1994),
Analytical Adjustments to Long-Term Debt
to Equity Ratio— Appendix 11C
Ratio Adjustment
M S ALRN D TSE
N F LDLT
???
?
