liquidty analysis ii

7/17/2019 Liquidty Analysis II

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Copyright 2009 by The McGraw-Hill Companies, Inc. All rights resere!.McGraw-Hill"Irwin

FinancialStatement

Analysis

K R Subramanyam

John J Wild


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10CHAPTER

Credit Analysis


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Liquidity and Working Capital

Liquidity -Ability to convert assets into cash or to obtaincash to meet short-term obligations. Short-term - Conventionally viewed as a period up to

one year. Working Capital - The ecess o! current assets over

current liabilities.

Liquidity -Ability to convert assets into cash or to obtaincash to meet short-term obligations.

Short-term - Conventionally viewed as a period up toone year.

Working Capital - The ecess o! current assets overcurrent liabilities.

Basics


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# Current Assets- Cash and other assets reasonably epected tobe $1% reali&ed in cash' or $2% sold or consumed' during the longero! one-year or the operating cycle.

# Current liabilities- (bligations to be satis!ied within a relativelyshort period' usually a year.

# Working Capital- )cess o! current assets over current liabilities

* +idely used measure o! short-term li,uidity

* Constraint !or technical de!ault in many debt agreements

# Current Ratio* atio o! Current Assets to Current iabilities

* elevant measure o! current liability coverage' bu!!er against losses'reserve o! li,uid !unds.

* imitations * A static measure

Basics


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# umerator Considerations* Adustments needed to counter limitations such as

# ailure to re!lect open lines o! credit

# Adust securities4 valuation since the balance sheet date

# e!lect revolving nature o! accounts receivable

# ecogni&e pro!it margin in inventory

# Adust inventory values to mar5et

# emove de!erred charges o! dubious li,uidity !rom prepaidepenses

# 6enominator Considerations* 7ayables vary with sales.

* Current liabilities do not include prospective cash outlays.

Current Ratio


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# i,uidity depends to a large etent on prospective cash!lows and to a lesser etent on the level o! cash and

cash e,uivalents.# o direct relation between balances o! wor5ing capital

accounts and li5ely patterns o! !uture cash !lows.# 9anagerial policies regarding receivables and

inventories are directed primarily at e!!icient and

pro!itable asset utili&ation and secondarily at li,uidity.

# Two elements integral to the use o! current ratio* :uality o! both current assets and current liabilities.* Turnover rate o! both current assets and current liabilities.

Current Ratio


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# Comparative Analysis* Trend analysis

# atio 9anagement $window dressing%

* Toward close o! a period' management will occasionally press thecollection o! receivables' reduce inventory below normal levels' anddelay normal purchases.

# ule o! Thumb Analysis $21%* Current ratio above 21 - superior coverage o! current liabilities $but not

too high - ine!!icient resource use and reduced returns%

* Current ratio below 21 - de!icient coverage o! current liabilities# ote o! caution* :uality o! current assets and the composition o! current liabilities are

more important in evaluating the current ratio.* +or5ing capital re,uirements vary with industry conditions and the

length o! a company4s net trade cycle.

Current Ratio - Applications


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10-ross or et?

# Trend Analysis

* Collection period over time.* (bserving the relation between the provision !or

doubt!ul accounts and gross accounts receivable.

%nterpretation o! Recei#ables Liquidity easures


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%llustration &'ay(s sales in in#entory)

$perating Acti#ity Analysis o! Liquidity

# @nventory turnover ratio

* 9easures the average rate o! speed at which inventoriesmove through and out o! a company.

# 6ays4 Sales in @nventory

* Shows the number o! days re,uired to sell ending inventory

# An alternative measure - 6ays to sell inventory ratio

%n#entory *urno#er easures

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* :uality o! inventory

* 6ecreasing inventory turnover

# Analy&e i! decrease is due to inventory buildup inanticipation o! sales increases' contractual commitments'increasing prices' wor5 stoppages' inventory shortages' orother legitimate reason.

* @nventory management

* )!!ective inventory management increases inventoryturnover.

%nterpreting %n#entory *urno#er

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* Conversion period oroperating cycle

# 9easure o! the speed

with which inventory isconverted to cash

%nterpreting %n#entory *urno#er

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# Current liabilities are important in computing wor5ingcapital and current ratio* sed in determining whether su!!icient margin o! sa!ety eists.

* 6educted !rom current assets in arriving at wor5ing capital.

# :uality o! Current iabilities* 9ust be udged on their degree o! urgency in payment

* 9ust be aware o! unrecorded liabilities having a claim oncurrent !unds

Liquidity o! Current Liabilities

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# 6ays4 7urchases in Accounts 7ayable

* 9easures the etent accounts payable representcurrent and not overdue obligations.

# Accounts 7ayable Turnover

* @ndicates the speed at which a company pays !orpurchases on account.

'ays( +urchases in Accounts +ayable

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Additional Liquidity easures

* @ndicator o! wor5ing capital li,uidity

@llustration

Current Assets Composition

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10-1ross pro!it $H


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Basics o! Sol#ency

# Sol#encyF long-run !inancial viability and its ability tocover long-term obligations

# Capital structureF !inancing sources and their attributes# 3arning poerF recurring ability to generate cash !rom

operations# Loan co#enantsF protection against insolvency and!inancial distressB they de!ine de!ault $and the legalremedies available when it occurs% to allow theopportunity to collect on a loan be!ore severe distress

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Basics o! Sol#ency

# 3quity !inancing* Risk capital o! a company* 4ncertain and unspeci!ied return* Lack o! any repayment pattern

* Contributes to a company(s stabilityand sol#ency

# 'ebt !inancing* ust be repaid ith interest* Speci!ied repayment pattern

# When the proportion o! debt!inancing is higher5 the higher arethe resulting !i,ed charges andrepayment commitments

Capital Structure

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Basics o! Sol#ency

# rom a shareholder4s perspective' debt is apre!erred eternal !inancing source

* @nterest on most debt is !ied* @nterest is a ta-deductible epense

# Financial le#erage - the amount o! debt!inancing in a company4s capital structure.* Companies with !inancial leverage are said to be

trading on the e,uity.

9otivation !or 6ebt

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Basics o! Sol#ency

inancial everage- @llustrating Ta 6eductibility o! @nterest

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Basics o! Sol#ency

7otential accounts needing adustments Chapter re!erence

# 'e!erred %ncome *a,es - @s it a liability' 3 8

e,uity' or some o! both?# $perating Leases - capitali&e non- 3

cancelable operating leases?

# $!! Balance Sheet Financing 3

# Contingent Liabilities 3 8

# inority %nterests /

# Con#ertible 'ebt 3

# +re!erred Stock 3

7otential accounts needing adustments Chapter re!erence

# 'e!erred %ncome *a,es - @s it a liability' 3 8

e,uity' or some o! both?# $perating Leases - capitali&e non- 3

cancelable operating leases?

# $!! Balance Sheet Financing 3

# Contingent Liabilities 3 8

# inority %nterests /# Con#ertible 'ebt 3

# +re!erred Stock 3

Ad6ustments !or Capital Structure - Liabilities

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Capital Structure Composition and Sol#ency

# Composition analysis

* 7er!ormed by constructing a common-si&e statement o! theliabilities and e,uity section o! the balance sheet.

* eveals relative magnitude o! !inancing sources.

Common-Si&e Statements in Solvency Analysis

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# Total 6ebt to Total Capital atio* Comprehensive measure o! the relation between total debt and

total capital

* Also called Total debt ratio

# Total 6ebt to ),uity Capital

# ong-Term 6ebt to ),uity Capital* 9easures the relation o! T debt to e,uity capital.

* Commonly re!erred to as the debt to e,uity ratio.# Short-Term 6ebt to Total 6ebt

* @ndicator o! enterprise reliance on short-term !inancing.

* sually subect to !re,uent changes in interest rates.

Capital Structure atios

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# Capital structure measures serve as screeningdevices.

# urther analysis re,uired i! debt is a signi!icantpart o! capitali&ation.

@nterpretation o! Capital Structure 9easures

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# Asset composition in solvency analysis* @mportant tool in assessing capital structure ris5 eposure.

* Typically evaluated using common-si&e statements o! assetbalances.

Asset-Eased 9easures o! Solvency

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3arnings Co#erage

# imitation o! capital structure measures - inability to!ocus on availability o! cash !lows to service debt.

# ole o! earnings co#erage' or earning poer' as thesource o! interest and principal repayments.

# )arnings to !ied charges ratio

)arnings to ied Charges

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3arnings Co#erage

)arnings to ied Charges

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Earnings to Fixed Charges Ratio

Calculation:

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3arnings Co#erage

# Times interest earned ratio* Considers interest as the only !ied charge needing

earnings coverage

* umerator sometimes re!erred to as earnings be!ore

interest and taes' or )E@T.* 7otentially misleading and not as e!!ective an analysis

tool as the earnings to !ied charges ratio.

Times @nterest )arned

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3arnings Co#erage

# Cash !low to !ied charges ratio* Computed using cash !rom operations rather than

earnings in the numerator o! the earnings to !iedcharges ratio.

elation o! Cash low to ied Charges

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3arnings Co#erage

# )arnings coverage o! pre!erred dividends ratio* Computation must include in !ied charges all ependitures

ta5ing precedence over pre!erred dividends.* Since pre!erred dividends are not ta deductible' a!ter-ta

income must be used to cover them.

)arnings Coverage o! 7re!erred 6ividends

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3arnings Co#erage

* )arnings coverage measures provide insight into theability o! a company to meet its !ied charges

* Nigh correlation between earnings-coveragemeasures and de!ault rate on debt

* )arnings variability and persistence is important

* se earnings beforediscontinued operations'etraordinary items' and cumulative e!!ects o!accounting changes !or single year analysis F but'include them in computing the averagecoverageratio over several years

@nterpreting )arnings Coverage

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3arnings Co#erage

# A company can increase ris5s $and potential returns% o!e,uity holders by increasing leverage

# Substitution o! debt !or e,uity yields a ris5ier capitalstructure

# elation between ris5 and return in a capital structureeists

# (nly personal analysis can re!lect one4s

uni,ue ris5 and return epectations

Capital Structure is5 and eturn

Return7

Risk1

liquidty analysis ii

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