Professional Documents
Culture Documents
Statement
Analysis
K R Subramanyam
John J Wild
McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
10-2
Credit Analysis
10
CHAPTER
10-3
Illustration
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 30
Inventories 30,000 30 50,000 50 %
Total current assets $100,000 100 % $100,000 100
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
Sales $750,000
Cost of sales 520,000
Purchases 350,000
Depreciation 25,000
Net income 20,000
(continued)
10-23
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
10-25
Basics of Solvency
Capital Structure
• 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
Basics of Solvency
Motivation for Debt
• 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.
10-27
Basics of Solvency
Financial Leverage- Illustrating Tax Deductibility of Interest
10-28
Basics of Solvency
Adjustments for Capital Structure - Liabilities
Potential
Potentialaccounts
accountsneeding
needingadjustments
adjustments Chapter
Chapterreference
reference
•• Deferred
DeferredIncome
IncomeTaxes Taxes--IsIsititaaliability,
liability, 33&&66
equity,
equity, or or some
some ofof both?
both? To To thth extent
extent future
future reversals
reversals are
are aa remote
remote
possibility,
possibility, asas conceivable
conceivable with with timing
timing differences
differences from
from accelerated
accelerated
depreciation,
depreciation,deferred
deferredtaxes
taxesshould
shouldbe beviewed
viewedlike
likelong-term
long-termfinancing
financingandand
treated
treatedlike
likeequity.
equity.However,
However,ififthethelikelihood
likelihoodofofaadrawing
drawingdown
downof ofdeferred
deferred
taxes
taxesininthe
theforceable
forceablefuture
futureisishigh,
high,thenthendeferred
deferredtaxes
taxes(or
(orpart
partofofthem)
them)
should
shouldbebetreated
treatedlike
likelong-term
long-termliabilities.
liabilities.
•• Operating
OperatingLeases
Leases--capitalize
capitalizenon-
non- 33
cancelable
cancelableoperating
operatingleases?
leases?
10-31
Earnings Coverage
Earnings to Fixed Charges
• 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
10-37
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.
10-38
Earnings Coverage
Earnings to Fixed Charges
10-39
Earnings Coverage
Times Interest Earned
• Times interest earned ratio
– Considers interest as the only fixed charge needing
earnings coverage:
Earnings Coverage
Earnings Coverage
Earnings 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
10-44
Earnings Coverage