Financial Statement Analysis

1. Financial Statement Analysis K R Subramanyam John J Wild

2. Credit Analysis 10 CHAPTER

3. Liquidity and Working Capital Basics •Liquidity - Ability to convert assets into cash or to obtain cash to meet short-term obligations. • Short-term - Conventionally viewed as a period up to one year. •Working Capital - The excess of current assets over current liabilities.

4. Liquidity and Working Capital • 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 Basics

5. Liquidity and Working Capital • 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. Current Ratio

6. Liquidity and Working Capital • 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. Current Ratio

7. Liquidity and Working Capital • 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 company’s net trade cycle. Current Ratio - Applications

8. Liquidity and Working Capital Current Ratio - Applications • Net Trade Cycle Analysis

9. Cash + Cash equivalents + Marketable securitiesCurrent Assets Cash + Cash equivalents + Marketable securitiesCurrent Liabilities Liquidity and Working Capital • Cash to Current Assets Ratio • Larger the ratio, the more liquid are current assets • Cash to Current Liabilities Ratio • Larger the ratio, the more cash available to pay current obligations Cash-Based Ratio Measures of Liquidity

10. Operating Activity Analysis of Liquidity • Accounts Receivable Turnover • Days’ Sales in Receivables • Receivables collection period Accounts Receivable Liquidity Measures

11. Operating Activity Analysis of Liquidity • 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. Interpretation of Receivables Liquidity Measures

12. Operating Activity Analysis of Liquidity • Inventory turnover ratio: • Measures the average rate of speed at which inventories move through and out of a company. • Days’ Sales in Inventory: • Shows the number of days required to sell ending inventory • An alternative measure - Days to sell inventory ratio: Inventory Turnover Measures Illustration (Day’s sales in inventory)

13. Operating Activity Analysis of Liquidity • 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. Interpreting Inventory Turnover

14. Operating Activity Analysis of Liquidity • Conversion period or operating cycle: • Measure of the speed with which inventory is converted to cash Interpreting Inventory Turnover

15. Operating Activity Analysis of Liquidity • 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 Liquidity of Current Liabilities

16. Operating Activity Analysis of Liquidity • 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. Days’ Purchases in Accounts Payable

17. Additional Liquidity Measures • Indicator of working capital liquidity Illustration Current Assets Composition

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.

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 • Management’s Discussion and Analysis • MD&A requires a discussion of liquidity – including known trends, demands, commitments, or uncertainties likely to impact the company’s ability to generate adequate cash.

20. Additional Liquidity Measures • Technique to trace through the effects of changes in conditions/ policies on cash resources of a company What-if analysis

21. Additional Liquidity Measures 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

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 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 • (continued)

23. 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 What-if analysis - Illustration

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

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 • When the proportion of debt financing is higher, the higher are the resulting fixed charges and repayment commitments

26. Basics of Solvency • 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. Motivation for Debt

27. Basics of Solvency Financial Leverage- Illustrating Tax Deductibility of Interest

28. Basics of Solvency Adjustments for Capital Structure - Liabilities Potential accounts needing adjustmentsChapter 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 • Contingent Liabilities 3 & 6 • Minority Interests 5 • Convertible Debt 3 • Preferred Stock 3

29. Capital Structure Composition and Solvency • 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. Common-Size Statements in Solvency Analysis

30. Capital Structure Composition and Solvency • 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. Capital Structure Ratios

31. Capital Structure Composition and Solvency • Capital structure measures serve as screening devices. • Further analysis required if debt is a significant part of capitalization. Interpretation of Capital Structure Measures

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

33. Earnings Coverage • 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 Earnings to Fixed Charges

34. Earnings Coverage Earnings to Fixed Charges

35. Earnings to Fixed Charges Ratio Calculation:

36. Earnings Coverage • 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. Times Interest Earned

37. Earnings Coverage • Cash flow to fixed charges ratio • Computed using cash from operations rather than earnings in the numerator of the earnings to fixed charges ratio. Relation of Cash Flow to Fixed Charges

38. Earnings Coverage • 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. Earnings Coverage of Preferred Dividends

39. 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 Interpreting Earnings Coverage

40. Earnings Coverage • 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 Capital Structure Risk and Return Return $ Risk ?