Financial

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

Liquidity and Working Capital

Basics
Liquidity
Liquidity--Ability
Abilityto
toconvert
convertassets
assetsinto
intocash
cashor
orto
toobtain
obtain
cash
cashto
tomeet
meetshort-term
short-termobligations.
obligations.
Short-term
Short-term--Conventionally
Conventionallyviewed
viewedas
asaaperiod
periodup
upto
to
one
oneyear.
year.
Working
WorkingCapital
Capital--The
Theexcess
excessof
ofcurrent
currentassets
assetsover
over
current
currentliabilities.
liabilities.

10-4

Liquidity and Working Capital

Basics

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

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

10-5

Liquidity and Working Capital

Current Ratio
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.

10-6

Liquidity and Working Capital

Current Ratio
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.

10-7

Liquidity and Working Capital

Current Ratio - Applications
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 companys net trade cycle.

Liquidity and Working Capital

Current Ratio - Applications

Net Trade Cycle Analysis

10-8

10-9

Liquidity and Working Capital

Cash-Based Ratio Measures of Liquidity
Cash to Current Assets Ratio
Cash + Cash equivalents + Marketable securities
Current Assets

Larger the ratio, the more liquid are current assets

Cash to Current Liabilities Ratio

Cash + Cash equivalents + Marketable securities
Current Liabilities

Larger the ratio, the more cash available to pay current

obligations

10-10

Operating Activity Analysis of Liquidity

Accounts Receivable Liquidity Measures

Accounts Receivable Turnover

Days Sales in Receivables

Receivables collection period

10-11

Operating Activity Analysis of Liquidity

Interpretation of Receivables Liquidity Measures

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.

10-12

Operating Activity Analysis of Liquidity

Inventory Turnover Measures
Inventory turnover ratio:
Measures the average rate of speed at which inventories
move through and out of a company.

Days Sales in Inventory:

Illustration (Days sales in inventory)

Shows the number of days required to sell ending inventory

An alternative measure - Days to sell inventory ratio:

10-13

Operating Activity Analysis of Liquidity

Interpreting Inventory Turnover
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.

10-14

Operating Activity Analysis of Liquidity

Interpreting Inventory Turnover
Conversion period or
operating cycle:

Measure of the speed

with which inventory is
converted to cash

10-15

Operating Activity Analysis of Liquidity

Liquidity of Current Liabilities
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

10-16

Operating Activity Analysis of Liquidity

Days Purchases in Accounts Payable

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.

10-17

Additional Liquidity Measures

Current Assets Composition
Indicator of working capital liquidity
Illustration

10-18

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.

10-19

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

Managements Discussion and Analysis

MD&A requires a discussion of liquidity
including known trends, demands, commitments,
or uncertainties likely to impact the companys
ability to generate adequate cash.

10-20

Additional Liquidity Measures

What-if analysis

Technique to trace through the effects of

changes in conditions/ policies on cash
resources of a company

10-21

Additional Liquidity Measures

What-if analysis Illustration
Background DataConsolidated Technologies at December 31, Year 1:
Cash
Accounts receivable
Inventory
Accounts payable
Notes payable
Accrued taxes
Fixed assets
Accumulated depreciation
Capital stock

$ 70,000
150,000
65,000
130,000
35,000
18,000
200,000
43,000
200,000

The following additional information is reported for Year 1:

Sales
Cost of sales
Purchases
Depreciation
Net income

$750,000
520,000
350,000
25,000
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

10-22

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 companys cash
balance? Will this change affect the companys need to borrow?
Our analysis of this what-if situation is as follows:
Cash, January 1, Year 2
Cash collections:
Accounts receivable, January 1, Year 2
Sales
Total potential cash collections
Less: Accounts receivable, December 31, Year 2
Total cash available
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)
Notes payable, January 1, Year 2
$ 35,000
Notes payable, December 31, Year 2
( 50,000)
Accrued taxes
Cash expenses(d)
Cash, December 31, Year 2
Cash balance desired
Cash excess

$ 70,000
$ 150,000
825,000
$ 975,000
( 206,250)(a)

768,750
$ 838,750

$ 543,000
(15,000)
18,000
203,500

749,500
$ 89,250
50,000
$ 39,250

(continued)

10-23

Additional Liquidity Measures

What-if analysis - Illustration
Explanations:
(a)

(b)Year 2 cost of sales*: $520,000 1.1 = $

Ending inventory (given)
Goods available for sale
$
Beginning inventory
Purchases
$
* Excluding depreciation.
(c)

572,000
150,000
722,000
(65,000)
657,000

(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).

10-24

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

Debt financing

Risk capital of a company

Uncertain and unspecified return
Lack of any repayment pattern
Contributes to a companys stability
and solvency

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

10-26

Basics of Solvency
Motivation for Debt

From a shareholders 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 companys 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,
equity,
equity,or
orsome
someofofboth?
both?
Operating
OperatingLeases
Leases--capitalize
capitalizenonnoncancelable
cancelableoperating
operatingleases?
leases?
Off
OffBalance
BalanceSheet
SheetFinancing
Financing
Contingent
ContingentLiabilities
Liabilities
Minority
MinorityInterests
Interests
Convertible
ConvertibleDebt
Debt
Preferred
PreferredStock
Stock

33&&66
33
33
33&&66
55
33
33

10-29

Capital Structure Composition and Solvency

Common-Size Statements in Solvency Analysis
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.

10-30

Capital Structure Composition and Solvency

Capital Structure Ratios
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.

10-31

Capital Structure Composition and Solvency

Interpretation of Capital Structure Measures

Capital structure measures serve as screening

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

10-32

Capital Structure Composition and Solvency

Asset-Based Measures of Solvency
Asset composition in solvency analysis
Important tool in assessing capital structure risk exposure.
Typically evaluated using common-size statements of asset
balances.

10-33

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.
Earnings to fixed charges ratio

10-34

Earnings Coverage
Earnings to Fixed Charges

10-35

Earnings to Fixed Charges Ratio

Calculation:

10-36

Earnings Coverage
Times Interest Earned

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.

10-37

Earnings Coverage
Relation of Cash Flow to Fixed Charges

Cash flow to fixed charges ratio

Computed using cash from operations rather than
earnings in the numerator of the earnings to fixed
charges ratio.

10-38

Earnings Coverage
Earnings Coverage of Preferred Dividends

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.

10-39

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

10-40

Earnings 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 ones
unique risk and return expectations
Return
$

Risk
?