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11CHAPTER

Credit Analysis

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Company Liquidity refers to the ability to meet short-term obligations

Liqu id i ty is the ability to convertassets into cash or toobtain cash

Short term is the longer of one-year or the company operating cycle

Liquidity and Working CapitalBasics

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Severe illiquidity often precedes

Lower profitability Restricted opportunities Loss of owner control Loss of capital investment

Insolvency and bankruptcy

Liquidity and Working CapitalBasics

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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 companys operating cycle

Current assets include:

Cash -- ultimate liquid assetCash equiv alents -- temporary investments of excess cash

Marketable secu rit ies -- debt or equity securities held as s-t investmentsAc coun ts receivab le -- mounts due from credit salesInventories -- items held for sale in the normal course of businessPrepaid exp enses -- advance payments for services and supplies

Liquidity and Working CapitalCurrent Assets

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Classification as current assetdepends on:

1. Manaments intent2. 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 CapitalCurrent Assets

BalanceSheet

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Working capital more relevant when related to other keyvariables such as

SalesTotal assets

Working capital is of limited value as an absoluteamount

Liquidity and Working Capital

Working Capital

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Current Ratio Reflects on:

Current liability coverage -- assurance in covering currentliabilities

Buffer against losses -- margin of safety for shrinkage innoncash current assets Reserve of liquid funds --margin of safetyagainst uncertainties and shocks to cash flows

Liquidity and Working CapitalCurrent Ratio

sliabilitieCurrentassetsCurrent=ratioCurrent

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Current Ratio Limitations:

If liquidity is the ability to meet cash outflows with adequatecash inflows, then does the current ratio:

Measure and predict the pattern of future cash inflows andoutflows?

Measure the adequacy of future cash inflows to outflows?

Answer is generally no to both these questions

Current ratioIs a static measureDoes not have a causal relation to futurecash inflows


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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 inventoryAdjust inventory values to market

Remove deferred charges of dubious liquidity fromprepaid expenses


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Three important qualifications 1. Liquidity depends to a large extent on prospective cash

flows

2. No direct relation between working capital accountbalances and patterns of future cash flows

3. Managerial policies are directed primarily at efficient andprofitable asset utilization and secondly at liquidity

4. Cash flow forecasts and pro forma financial statementsare preferred over the current ratio for liquidity andsolvency analysis

5. Current ratio is a static measure of the ability of currentassets to satisfy current liabilities


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Two important elements are integral to use of the currentratio

1. Quality of both current assets and current liabilities

2. Turnover rate of both current assets and currentliabilities


Current Ratio

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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 thenused to pay off current liabilities

Liquidity and Working CapitalCurrent Ratio - Applications

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Rule of Thumb Analysis (2:1)

> 2:1 superior coverage of current liabilities (but nottoo high, suggesting inefficient use of resourcesand reduced returns)

< 2:1 deficient coverage of current liabilities


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Net Trade Cycle Analysis

Working capital requirements are affected by its desired

inventory investment and the relation between creditterms from suppliers and those extended to customers


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Net Trade Cycle IllustrationSelected financial information from Technology Resources, Inc., for the end of Year 1 isreproduced below:

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.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):


days66.24=(day s)cycletradeNet

days30.00=$666.67

$20,000=payable Acc ounts:Less

days96.24

days56.24=360$320,000

$50,000=sInv entorie

days40.00=360$360,000

$40,000=receiv able Accounts

Current Ratio - Applications

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Sales Trend Analysis

Trend analysis review of sales trend across time


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Cash to Current Assets Ratio

Larger the ratio, the more liquid are current assets

Liquidity and Working CapitalCash-Based Ratio of Liquidity

assetsCurrentsecuritiesMarketable+sequivalentCash+Cash

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Cash to Current Liabilities Ratio

Larger the ratio, the more cash available to pay currentobligations


sliabilitieCurrentsecuritiesMarketable+sequivalentCash+Cash

Cash-Based Ratio of Liquidity

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Accounts Receivable Turnover

Operating Activity Analysis of Liquidity

Accounts Receivable Liquidity

receivableaccounts AveragecreditonsalesNet

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Operating Activity Analysis of LiquidityAccounts Receivable Liquidity

Receivables Turnover for Selected Industries

0 20 40 60 80 100 120 140

Food stores

Eating and drinking

Motion pictures

Printing and publishing

Electrical equipment

Educational services

General merchandise

Receivables turnover Source: Dun & Bradstreet

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Accounts Receivable Collection Period



turnover receivable Accounts360=periodCollection

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Days Sales in Receivables (Alternative to Collection Period)



360Sales ReceivableAccount

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Temporal Trend Analysis

Trend in:

1. Collection period over time

2.



receivableaccountsGross

accountsdoubtfulfor Provision

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Inventory Turnover

Measures the average rate of speed inventories movethrough and out of a company


Inventory Turnover

inventory Averagesoldgoodsof Cost

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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 days sales is:

Shows the number of days required to sell ending inventory


Inventory Turnover

turnover Inventory360

salessday'averageof CostinventoryEnding

360soldgoodsof Cost

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Selected financial information from Macon Resources, Inc., for the end of Year 8 is reproduced below:

Sales $1,800,000Cost of goods sold 1,200,000Beginning inventory 200,000Ending inventory 400,000

Inventory turnover ratios using average inventory are computed as:

Inventory turnover ratios based on ending inventory equal:


Inventory Turnover - Illustration

days Days

Inventory

90

42)000,400$000,200($

4360

=ratioinventorysellto

$1,200,000=ratioturnover

days$3,333

$400,000=inventoryinsalesDays'

$1,200,000=salessday'averageof Cost

120

333,3$360

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Conversion Period (Operating Cycle):

Days to Sell Inventory + Collection Period

Measure of the speed with which inventory is convertedto cash


Inventory Turnover

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Quality of Current Liabilities

Must be judged on their degree of urgency inpayment

Must be aware of unrecorded liabilities having a claimon 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


Inventory Turnover

360PurchasespayableAccounts= payableaccountsin purchasesDays

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Acid-Test (Quick) Ratio

sliabilitieCurrentreceivable Accounts+securitiesMarketable+sequivalentCash+Cash

Is a more stringent test of liquidityvis--vis current ratio

Additional Liquidity Measures

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Dun & Bradstreet's Quick Ratio for SelectedIndustries

0 0.3 0.6 0.9 1.2 1.5

Food storesEating and drinking

Motion pictures




General merchandise

Ratio

Acid-Test (Quick) RatioAdditional Liquidity Measures

Source: Dun & Bradstreet

(Cash + Account Receivables/Current Liabilities)

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Cash Flow Measures

Cash Flow Ratio

A ratio of 0.40 or higher is common for healthy companies

sliabilitieCurrentflowcashOperating


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Financial Flexibility

Financial flexibility - ability of a company to take stepsto counter unexpected interruptions in the flow of funds

Focus of analysis:

Ability to borrow from varioussources

To raise equity capital To sell and redeploy assets To adjust the level and direction of

operations to meet changingcircumstances

Levels of prearranged financing andopen lines of credit


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Managements 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


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What-If Analysis

What-if analysis -- technique to trace through theeffects of changes in conditions or policies on thecash resources of a company

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What-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 200,000

Accumulated depreciation 43,000Capital stock 200,000

The following additional information is reported for Year 1:

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

Net income 20,000Anticipates 10 percent growth in sales for Year 2All revenue and expense items are expected to increase by 10 percent, except for depreciation, which remains the sameAll expenses are paid in cash as they are incurred

Year 2 ending inventory is projected at $150,000By 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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Solvency -- long-run financial viability andits ability to cover long-term obligations

Capital structure -- financing sourcesand their attributes

Earning power recurring ability togenerate cash from operations

Loan covenan ts protection against insolvency andfinancial distress; they define defaul t (and the legalremedies available when it occurs) to allow theopportunity to collect on a loan before severe distress

Basic of SolvencyFacts

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Equity financing Risk capital of a company Uncertain and unspecified return Lack of any repayment pattern Contributes to a companys 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 SolvencyCapital Structure

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f l

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Trading on the Equity Returns for Different Earnings Levels ($ thousands)

Financing Sources Return on

Income beforeInterest 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 6.0Safety, 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 1.0Safety, 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

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B i f S l

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Financial Leverage Ratio

Greater the proportion of financing from equity vs. debtlower the financial leverage ratio

Note: Financial leverage ratio is a componentof the disaggregated return on equity see Chapter 8

Basic of SolvencyFinancial Leverage

capitalequityCommon

assetsTotal

B i f S l

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Potential accounts needing adjustments Chapter reference

Deferred Income Taxes Is it a liability, 3 & 6equity, or some of both?

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

Off-Balance-Sheet Financing 3Pensions and Postretirement Benefits 3Unconsolidated Subsidiaries 5

Contingent Liabilities 3 & 6Minority Interests 5Convertible Debt 3Preferred Stock 3

Basic of SolvencyAdjustments for Capital Structure - Liabilities

BalanceSheet

B i f S l

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Potential accounts needing adjustments Chapter reference

Inventories LIFO Reserve? 4

Marketable Securities 4

Intangible Assets 4 & 5

Basic of SolvencyAdjustments for Capital Structure - Assets

Balance

Sheet

C i l S d S l

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Projection of Future Cash Inflows and Outflows

Reflects on risk for a levered companys capital structure

Prepare a Statement of Forecasts of Cash Inflows andOutflows

Capital Structure and SolvencyLong-Term Projections

Chapter 10 described and illustrated long-term cash flow forecasts

C it l St t d S l

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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 differentcompanies

Two Variations (1) Use ratios, and (2) Exclude currentliabilities

Capital Structure and SolvencyCommon-Size Statements

C it l St t d S l

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Total Debt to Total Capital (also called total debt ratio )

Capital Structure and Solvency

Capital Structure Measures

capitalTotaldebtTotal

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C it l St t d S l

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Total Debt to Equity Capital

Reciprocal measure of this ratio E quity Capital toTotal Debt

Capital Structure and SolvencyCapital Structure Measures

equityshareholder SdebtTotal

debtTotalequityshareholder S

C it l St t d S l

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Long -Term Debt to Equity Capital (also calledDebt to Equity)


equityshareholder Sdebtterm-Long

Capital Structure Measures

C pit l Str ct re nd Sol enc

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Capital Structure and SolvencyCapital Structure Measures

Total Debt to Equity

0.0 0.2 0.4 0.6 0.8 1.0

Food storesEating and drinking

Motion pictures




General merchandise

RatioSource: Dun & Bradstreet

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Common-size and ratio analyses of capital structure mainly reflectcapital structure r isk

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 analysisto 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 SolvencyInterpretation of Capital Structure Measures


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Asset Composition Analysis

Tool in assessing the risk exposure of a capital structureTypically evaluated using common-size statements


Asset-Based Measures of Solvency


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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 SolvencyAsset-Based Measures of Solvency

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Additional Liquidity MeasuresEarnings 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 manycharacteristics 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 [Preferredstock 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.

essubsidiariowned-majorityof tsrequiremendividendstockpreferred

adjusted-Tax)(expensesrentaloperatingof portionInterest)(premium

or discountandexpensedebtof ionAmortizat)(incurredinterestTotal)(

affiliatesor essubsidiariowned-percent-50thanlessof incometedUndistribu)(periodtheinamortized

interestdcapitalizeprev iouslyof Amount)(essubsidiariowned-majorityof

tsrequiremendividendstockpreferredadjusted-Tax)(expensesrentaloperatingof

portionInterest)(premiumor discountandexpensedebtof ionAmortizat)( expenseInterest)(operationscontinuingfromincometax-Pre)(

e plus d plus

c plus h

g minus

f plus

e plus

d plus c plus b plus a

Earning Coverage

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Earning Coverage Earnings to Fixed Charges - Illustration

COMPUTECH CORPORATIONIncome Statement

Net sales $ 13,400,000Income of less than 50%-owned affiliates (all[nb]undistributed) 600,000Total revenue $ 14,000,000

Cost of goods sold $ 7,400,000Selling, general, and administrative expenses 1,900,000Depreciation (excluded from above costs)3 800,000Interest expense1net 700,000Rental expense2 800,000Share of minori ty interests in consolidated income4 200,000 11,800,000 Income before taxes $ 2,200,000

Income taxes:Current $ 800,000Deferred 300,000 (1,100,000)

Income before extraordinary item $ 1,100,000Extraordinary gain (net of $67,000 tax) 200,000Net income $ 1,300,000

Dividends:On common stock $ 200,000On preferred stock 400,000 600,000

Earnings retained for the year $ 700,000Selected notes to the financial statements:1 Interest expense is composed of the following:Interest incurred (except items below) $ 740,000Amortization of bond discount 60,000

Interest portion of capitalized leases 100,000Interest capitalized (200,000)Interest expense $ 700,000

2 Interest implicit in noncapitalized leases amounts to $300,000.3 Depreciation includes amortization of previously capitalized interest of $80,000.4 These subsidiaries have fixed charges.

Additional information (during the income statement period):Increase in accounts receivable $ 310,000Increase in inventories 180,000Increase in accounts payable 140,000Decrease in accrued taxes 20,000

Earnings to fixed charges ratio:$2, ( ) $ 700200

2 4 0a b c d f g

h c d

( ) $ 300 ( ) $80 ( ) $ 600 ( ) $ 200$8 40 ( ) $6 0 ( ) $3 00 ( )

.*an d

*Note: The SEC permits including in income the minority interest in the income of majority-owned subsidiaries having fixedcharges. This amount is added to reverse a similar deduction from income.

Earning Coverage

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Earning Coverage

Tiimes Interest Earned

Times interest earned ratio

expenseInterestexpenseInterest+expenseTax+Income

Earning Coverage

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Earning Coverage

Cash Flow to Fixed Charges

Cash Flow to Fixed Charges Ratio

chargesixedF (g) (b)sAdjustment+flowcashoperatingtax-Pre

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Earning Coverage

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Earning Coverage

Earnings Coverage of Preferred Dividends

Earnings coverage of preferred dividends ratio:

rateTax1dividendsPreferred

+chargesixedF

(g)(b)Adjusted+incometax-Pre

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Rating Debt Obligations Appendix 11A

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Criteria determining a specific rating involve bothquant i ta t ive and qual i ta t ive factors

Asset protection Financial resources Earning power Management

Debt provisions Other: Company size, market share, industry position,cyclical influences, and economic conditions


Rating Criteria


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Ratings and Yields

g g pp

Source: Standard & Poors, 2002

10-Year Treasury and Corporate Bond Yields - 2002

0 1 2 3 4 5 6 7

Treasury

AAA

AA

A

Percent


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Bo nd Quali ty Rat ings Rat ing Grades Standard & Poors Moodys

Highest grade AAA AaaHigh grade AA AaUpper medium A ALower medium BBB Baa

Marginally speculative BB BaHighly speculative B B, CaaDefault D Ca, C

Rating Criteria

g g pp

Predicting Financial Distress Appendix 11B

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X 1 = Working capital/Total assetsX 2 = Retained earnings/Total assetsX 3 = Earnings before interest and taxes/Total assetsX 4 = Shareholders equity/Total liabilitiesX 5 = Sales/Total assets

Z2.90 implies a low probability of bankruptcy1.20

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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 statementsprior to 1994)

to Equity Ratio Appendix 11C Ratio Adjustment

MSALR NDT SE

NFL D LT

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Ch11PPTs