Chapter 10 - Credit Analysis Analysis
Chapter 10 Credit Analysis REVIEW This chapter focuses on credit analysis. It is separated into two major sections li!uidity analysis and sol"ency analysis. #i!uidity refers to the a"aila$ility of resources to meet short%term cash re!uirements. A company&s short%term li!uidity ris' is affected $y the timin( of cash inflows and outflows alon( with its prospects for future performance. )ur analysis of li!uidity is aimed at companies& operatin( acti"ities* their a$ility to (enerate profit profits s from from the sale sale of (oo (oods ds and ser"ic ser"ices* es* and wor'in wor'in( ( capita capitall re!uir re!uireme ements nts and measures. This chapter descri$es se"eral financial statement analysis tools to assess short%term li!uidity ris' for a company. We $e(in with a discussion of the importance of li!uidity and its lin' to wor'in( capital. We e+plain and interpret useful ratios of $oth wor'in( capital and a company&s operatin( cycle for assessin( li!uidity li!uidity.. We also discuss potential potential adjustments adjustments to these analysis analysis tools tools and the underlyi underlyin( n( financial financial statement num$ers. What%if analysis of chan(es in a company&s conditions or strate(ies concludes this section. The second part of this chapter considers sol"ency analysis. ,ol"ency is an important facto factorr in ou ourr anal analys ysis is of a comp compan any& y&s s fina financ ncia iall stat statem emen ents ts.. ,ol" ,ol"en ency cy refer refers s to a company&s lon(%run financial "ia$ility and its a$ility to co"er lon(%term o$li(ations. All $usi $u sine ness ss acti acti"i "iti ties es of a comp compan anyy-fi fina nanc ncin in(* (* in"e in"est stin in(* (* and and op oper erat atin in((-af affe fect ct a company&s sol"ency. )ne of the most important components of sol"ency analysis is the composition of a company&s capital structure. Capital structure refers to a company&s source sources s of financ financin( in( and its econo economic mic attri$u attri$utes tes.. Thi This s chapte chapterr descri descri$es $es capita capitall structure and e+plains its importance to sol"ency analysis. ,ince sol"ency depends on success success in operatin( operatin( acti"ities* acti"ities* the chapter e+amines e+amines earnin(s earnin(s and its a$ility a$ility to cover important important and necessary necessary company company e+penditur e+penditures. es. ,pecifical ,pecifically ly** this chapter descri$es descri$es "arious tools of sol"ency analysis* includin( le"era(e measures* analytical accountin( adju adjust stme ment nts* s* capi capita tall stru struct ctur ure e anal analys ysis is** and and earn earnin in(s (s%c %co" o"er era( a(e e meas measur ures es.. We demonstrate these analysis tools with data from financial statements. We also discuss the relation $etween ris' and return inherent in a company&s capital structure* and its implications for financial statement analysis.
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Chapter 10 - Credit Analysis Analysis
)T#I/E ,ection 1 #i!uidity #i!uidity •
#i!uidity and Wor'in( Capital Current Assets and #ia$ilities Wor'in( Capital easure of #i!uidity Current Ratio easure of #i!uidity sin( the Current Ratio for Analysis Cash%ased Ratio easures of #i!uidity
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)peratin( Acti"ity Analysis of #i!uidity Accounts Recei"a$le #i!uidity #i!uidity easures In"entory Turno"er easures #i!uidity of Current #ia$ilities
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Additional #i!uidity easures Current Assets Composition Acid%Test 23uic'4 Ratio Cash 5low easures 5inancial 5le+i$ility ana(ement&s 6iscussion and Analysis
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What%If Analysis
,ection 7 Capital ,tructure and ,ol"ency •
Importance of Capital ,tructure Characteristics of 6e$t and E!uity oti"ation for 6e$t Capital Concepts of 5inancial #e"era(e Adjustments for Capital ,tructure Analysis
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Capital ,tructure Composition and ,ol"ency Common%,i8e Common%,i8e ,tatements in ,ol"ency Analysis Analysis Capital ,tructure easures for ,ol"ency Analysis Analysis Interpretation of Capital ,tructure easures Asset%ased Asset%ased easures of ,ol"ency
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Chapter 10 - Credit Analysis Analysis
)T#I/E ,ection 1 #i!uidity #i!uidity •
#i!uidity and Wor'in( Capital Current Assets and #ia$ilities Wor'in( Capital easure of #i!uidity Current Ratio easure of #i!uidity sin( the Current Ratio for Analysis Cash%ased Ratio easures of #i!uidity
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)peratin( Acti"ity Analysis of #i!uidity Accounts Recei"a$le #i!uidity #i!uidity easures In"entory Turno"er easures #i!uidity of Current #ia$ilities
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Additional #i!uidity easures Current Assets Composition Acid%Test 23uic'4 Ratio Cash 5low easures 5inancial 5le+i$ility ana(ement&s 6iscussion and Analysis
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What%If Analysis
,ection 7 Capital ,tructure and ,ol"ency •
Importance of Capital ,tructure Characteristics of 6e$t and E!uity oti"ation for 6e$t Capital Concepts of 5inancial #e"era(e Adjustments for Capital ,tructure Analysis
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Capital ,tructure Composition and ,ol"ency Common%,i8e Common%,i8e ,tatements in ,ol"ency Analysis Analysis Capital ,tructure easures for ,ol"ency Analysis Analysis Interpretation of Capital ,tructure easures Asset%ased Asset%ased easures of ,ol"ency
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Chapter 10 - Credit Analysis Analysis
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Earnin(s Co"era(e Relation of Earnin(s to 5i+ed Char(es Times Interest Earned Analysis Relation of Cash 5low to 5i+ed Char(es Earnin(s Co"era(e of 9referred 6i"idends 6i"idends Interpretin( Earnin(s Co"era(e easures
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Capital ,tructure Ris' and Return
Appendi+ 11A Ratin( 6e$t Appendi+ 11 9redictin( 9redict in( 5inancial 6istress
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Chapter 10 - Credit Analysis Analysis
A/A#: A/A#:,I, );ECTIVE, );ECTIVE, •
E+plain the importance of li!uidity in analy8in( $usiness acti"ities. acti"ities.
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6escri$e wor'in( capital measures of li!uidity li!uidity and their components.
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Interpret the current ratio and cash%$ased measures of li!uidity. li!uidity.
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Analy8e Analy8e operatin( cycle and turno"er measures of li!uidity li!uidity and their interpretation.
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Illustrate Illustrate what%if analysis for e"aluatin( chan(es in company conditions and policies. 6escri$e capital structure and its relation to sol"ency. sol"ency. E+plain financial le"era(e and its implications implications for company performance and analysis. Analy8e Analy8e adjustments to accountin( acc ountin( $oo' "alues to assess capital structure. 6escri$e analysis tools for e"aluatin( and interpretin( capital structure composition and for assessin( sol"ency.
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Analy8e Analy8e asset composition composition and co"era(e for sol"ency analysis.
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E+plain earnin(s%co"era(e analysis and its rele"ance in e"aluatin( sol"ency. sol"ency.
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6escri$e capital structure ris' and return and its rele"ance to financial statement analysis.
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Interpret ratin(s of or(ani8ations& de$t o$li(ations 2Appendi+ 11A4.
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6escri$e prediction models of financial distress 2Appendi+ 114.
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Chapter 10 - Credit Analysis Analysis
3E,TI)/, 1. #i!uidi #i!uidity ty is an indicator indicator of an entity&s entity&s a$ility a$ility to meet its current o$li(ati o$li(ations. ons. An An entity in a wea' short% short%ter term m li!uid li!uidity ity po posit sitio ion n wil willl ha"e ha"e diffic difficul ulty ty in meetin meetin( ( short%t short%term erm o$li(ations. This has implications for any current and potential sta'eholders of a company company.. 5or e+ample* e+ample* lac' of li!uidi li!uidity ty would would affect users< users< analysis analysis of financial financial statements in the followin( followin( ways Equity investor In this case* the company li'ely is una$le to a"ail itself of fa"ora$le discounts and to ta'e ad"anta(e of profita$le $usiness opportunities. It could e"en mean loss of control and e"entual partial or total loss of capital in"estment. Creditors In this case* delay in collection of interest and principal due would $e e+pected and there is a possi$ility of the partial or total loss of the amounts due them. 7. A major major limitati limitation on in usin( usin( wor'in( wor'in( capital 2in dollar dollars4 s4 as an analysis analysis measure measure is its failure to meanin(fully relate it to other measure for interpreti"e purposes. That is* wor'in( capital is much more meanin(ful when related to other amounts* such as current current lia$iliti lia$ilities es or total assets. In addition* addition* the importance importance attached to wor'in( capital $y "arious users pro"ides a stron( incenti"e for an entity 2especially the ones in a wea' financial position4 to stretch stretch the definition of its components. 5or e+ample* some mana(ers may =e+pand> the definition of what constitutes a current asset and a current lia$ility to $etter present their current position in the most fa"ora$le li(ht. oreo"er* there are se"eral opportunities for mana(ers to stretch these definitions. 5orr this 5o this reaso reason* n* the the anal analys ystt mu must st use use jud( jud(men mentt in e"al e"alua uati tin( n( mana mana(e (emen ment< t
rule4. In the case of fi+ed assets* there is the possi$ility of their their inclus inclusion ion in curren currentt assets assets und under er one condit condition ion.. The condit condition ion is that that mana(e mana(ement ment intend intends s to sell sell these these fi+ed fi+ed assets assets and mana(e mana(emen mentt has a defini definite te contractual commitment from a $uyer to purchase them at a specific price within the followin( followin( year 2or operatin( cycle* if lon(er4. @. Instal Installm lment ent recei"a recei"a$le $les s deri"e deri"ed d from from sales sales in the re(ular re(ular course course of $u $usin siness ess are deemed to $e collecti$le within the operatin( cycle of a company. Therefore* such installment installment recei"a$les are to $e included in current assets. . In"entor In"entories ies are not always reported reported as current assets. ,pecificall ,pecifically* y* in"entor in"entory y amounts in e+cess of current re!uirements should $e e+cluded from current assets. Current re!uirements include !uantities to $e used within one%year or the normal operatin( cycle* whiche"er period is lon(er. usiness at times $uilds up its in"entory in e+cess of current re!uirement to hed(e a(ainst an increase in price or in anticipation of a stri'e stri'e.. ,uch ,uch e+cess e+cess in"en in"entor tories ies $eyond $eyond the re!uir re!uiremen ements ts of one year year should should $e classified as noncurrent. B. 9repaid 9repaid e+penses represen representt ad"ance payments payments for ser"ices ser"ices and and supplies supplies that that would otherwise re!uire the current outlay of funds durin( the succeedin( one%year or a lon(er operatin( cycle.
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Chapter 10 - Credit Analysis
. an's usually reser"e the ri(ht not to renew the whole or part of a loan at their option when they si(n a re"ol"in( loan a(reement. The fact that a $an' a(rees informally to renew short%term notes does not ma'e them noncurrent. The possi$ility that the company under analysis included such notes under lon(%term lia$ilities should $e carefully assessed 2and potentially reclassified if our analysis su((ests otherwise4. D. ,ome of these industry characteristics* such as the a$sence of any distinction $etween current and noncurrent on the $alance sheet in the real estate industry* can indeed re!uire special treatment. owe"er* e"en in such cases* analysts should $e careful to consider whether these FspecialF characteristics chan(e the relation e+istin( $etween current o$li(ations and the li!uid funds a"aila$le 2or reasona$ly e+pected to $ecome a"aila$le4 to meet them. )ur analysis should adjust the classifications of any items not meetin( our assessment of the current and noncurrent criteria. G.
Identical wor'in( capital does not imply identical li!uidity. The a$solute amount of wor'in( capital has si(nificance only when related to other "aria$les such as sales* total assets* etc. The a$solute amount only has* at $est* a limited "alue for intercompany comparisons. A $etter (au(e of li!uidity when focusin( on wor'in( capital is to relate its amount to either or $oth of current assets and current lia$ilities 2or sales* assets* etc.4.
10. The current ratio is the ratio of current assets to current lia$ilities. It is a static measure of resources a"aila$le at a (i"en point in time to meet current o$li(ations. The reasons for its widespread use include It measures the de(ree to which current assets co"er current lia$ilities. It measures the mar(in of safety a"aila$le to allow for possi$le shrin'a(e in the "alue of current assets. It measures the mar(in of safety a"aila$le to meet the uncertainties and the random shoc's to which the flows of funds in a company are su$ject. • •
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11. Cash inflows and cash outflows are not perfectly predicta$le. 5or e+ample* in the case of a $usiness downturn* sales can decline more rapidly than do outlays for purchases and e+penses. The amount of cash held is in the nature of a precautionary reser"e* which is intended to ta'e care of short%term surprises in cash inflows and outflows. 17. There is a relation $etween in"entories and sales. ,pecifically* as sales increase 2decrease4* the in"entory le"el typically increases 2decreases4. owe"er* in"entories are a direct function of sales only in rare cases. ethods of in"entory mana(ement e+ist* and e+perience su((ests that in"entory increments "ary not in proportion to demand 2sales4 $ut rather with measure appro+imatin( the s!uare root of demand. 1?. ana(ement
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Chapter 10 - Credit Analysis
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There is no direct or esta$lished relationship $etween $alances of wor'in( capital items and the pattern which future cash flows are li'ely to assume.
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Chapter 10 - Credit Analysis
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ana(erial policies directed at optimi8in( the le"els of recei"a$les and in"entories are oriented primarily toward the efficient and profita$le utili8ation of assets and only secondarily at li!uidity considerations.
1. The limitations to which the current ratio is su$ject should $e reco(ni8ed and its use should $e restricted to the type of analytical tas' it is capa$le of ser"in(. ,pecifically* the current ratio can help assess the ade!uacy of current assets to dischar(e current lia$ilities. This implies that any e+cess 2called wor'in( capital4 is a li!uid surplus a"aila$le to meet im$alances in the flow of funds* shrin'a(e in "alue* and other contin(encies. 1B. Cash%$ased ratios of li!uidity typically refer to the ratio of cash 2includin( cash e!ui"alents4 to total current assets or to total current lia$ilities. The choice of deflator depends on the purposes of analysis. 2i4 The hi(her the ratio of cash to total current assets the more li!uid the current asset (roup is. This means that this portion of the total current assets is su$ject only to a minimal dan(er of loss in "alue in case of li!uidation and that there is practically no waitin( period for con"ersion of these assets into usa$le cash. 2ii4 The ratio of cash to total current lia$ilities measures how much cash and cash e!ui"alents are a"aila$le to immediately pay current o$li(ations. This is a se"ere test that i(nores the re"ol"in( nature of current lia$ilities. It supplements the cash ratio to total current assets in that it measures cash a"aila$ility from a somewhat different point of "iew. 1. An important measure of the !uality of current assets such as recei"a$les and in"entories is their turno"er. The faster the turno"er-collections in case of recei"a$les and sales in case of in"entories-the smaller the li'elihood of loss on ultimate reali8ation of these assets. 1D. The a"era(e accounts recei"a$le turno"er measures in effect the speed of their collection durin( the period. The hi(her the turno"er fi(ure* the faster the collections are* on a"era(e. 1G. The collection period 2or days& sales in accounts recei"a$le4 measures the num$er of days& sales uncollected. It can $e compared to a company&s credit terms to e"aluate the !uality of its collection acti"ities. 70. Either one or all of the followin( are possi$le reasons for an increase in the collection period A relati"ely poorer collection jo$. 6ifficulty in o$tainin( prompt payment for "arious reasons from customers in spite of dili(ent collection efforts. Customers in financial difficulty* which in turn may imply a poor jo$ $y the credit department. Chan(e of credit policies or sales terms in a desire to increase sales. E+cessi"e delin!uency of one or a few su$stantial customers. • •
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Chapter 10 - Credit Analysis
71. 2a4 If the in"entory le"el is inade!uate* the sales "olume may decline to $elow the le"el of sales otherwise attaina$le. A loss of potential customers can also occur. 2$4 E+cessi"e in"entories* howe"er* e+pose the company to e+penses such as stora(e costs* insurance* and ta+es as well as to ris's of loss of "alue throu(h o$solescence and physical deterioration. E+cessi"e in"entories also tie up funds that can $e used more profita$ly elsewhere. 77. The #I5) method of in"entory "aluation in times of increasin( costs can render $oth the in"entory turno"er ratio as well as the current ratio practically meanin(less. owe"er* there is information re(ardin( the #I5) reser"e that is reported in financial statements. se of the #I5) reser"e ena$les the analyst to adjust an unrealistically low #I5) in"entory "alue to a more meanin(ful in"entory amount. ,till* in intercompany comparati"e analysis* e"en if two companies use #I5) cost methods for their in"entory "aluations* the ratios $ased on such in"entory fi(ures may not $e compara$le $ecause their respecti"e #I5) in"entory pools 2$ases4 may ha"e $een ac!uired in years of si(nificantly different price le"els. 7?. The composition of current lia$ilities is important $ecause not all current lia$ilities represent e!ually ur(ent and forceful calls for payment. ,ome claims* such as for ta+es and wa(es* must $e paid promptly re(ardless of current financial difficulties. )thers* such as trade $ills and loans* usually do not represent e!ually ur(ent calls for payment. 7@. Chan(es in the current ratio o"er time do not automatically imply chan(es in li!uidity or operatin( results. In a prosperous year* (rowin( lia$ilities for ta+es can result in a lowerin( of the current ratio. oreo"er* in times of $usiness e+pansion* wor'in( capital re!uirements can increase with a resultin( contraction of the current ratioso%called Fprosperity s!uee8e.F Con"ersely* durin( a $usiness contraction* current lia$ilities may $e paid off while there is a concurrent 2in"oluntary4 accumulation of in"entories and uncollected recei"a$les causin( the ratio to rise. 5inally* ad"ances in in"entory practices 2such as just%in%time4 can lower the current ratio. 7. FWindow dressin(F refers to the adjustment of year%end account $alances of current assets and lia$ilities to show a more fa"ora$le current ratio than is otherwise warranted. This can $e accomplished* for e+ample* $y temporarily steppin( up the efforts for collection* $y temporarily recallin( ad"ances and loans to officers* and $y reducin( in"entory to $elow the normal le"el and use the proceeds from these steps to pay off current lia$ilities. The analyst should (o $eyond year%end reported amounts and try to o$tain as many interim readin(s of the current ratio as possi$le. E"en if the year%end current ratio is "ery stron(* interim ratios may re"eal that the company is dan(erously close to insol"ency. ore (enerally* our analysis must always $e aware of the possi$ility of window dressin( of $oth current and noncurrent accounts. 7B. The rule of thum$ re(ardin( the current ratio is 71 - a "alue $elow that le"el su((ests serious li!uidity ris'. Also* the rule of thum$ su((ests that the hi(her the current ratio $e a$o"e the 71 le"el* the $etter. The followin( points* howe"er* should $e 'ept in mind so as not to e+pose our analysis to undue ris's of errors in inferences A current ratio much hi(her than 7 to 1* while implyin( a superior co"era(e of current lia$ilities* can si(nal a wasteful accumulation of li!uid resources. •
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Chapter 10 - Credit Analysis
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It is the !uality of the current assets and the nature of the current lia$ilities that are more si(nificant in interpretin( the current ratio-not simply the le"el itself.
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Chapter 10 - Credit Analysis
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The need of a company for wor'in( capital "aries with industry conditions as well as with the len(th of its own net trade cycle.
7. In an assessment of the o"erall li!uidity of a company
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Chapter 10 - Credit Analysis
?1. Analysis of capital structure is important $ecause the financial sta$ility of a company and the ris' of insol"ency depend on the financin( sources as well as on the type of assets it holds and the relati"e ma(nitude of such asset cate(ories. ,pecifically* there are essential differences $etween de$t and e!uity* which are the two major sources of funds. E!uity capital has no (uaranteed return that must $e paid out and there is no timeta$le for repayment of the capital in"estment. 5rom the "iewpoint of a company* e!uity capital is permanent and can $e counted on to remain in"ested e"en in times of ad"ersity. Therefore* the company can confidently in"est e!uity funds in lon(%term assets and e+pose them to the (reatest ris's. )n the other hand* de$ts are e+pected to $e paid at certain specified times re(ardless of a company&s financial condition. To the in"estor in common stoc'* the e+istence of de$t contains a ris' of loss of in"estment. The creditors would want as lar(e a capital $ase as is possi$le as a cushion that will shield them a(ainst losses that can result from ad"ersity. Therefore* it is important for the financial analyst to re"iew carefully all the elements of the capital structure. ?7. 5inancial le"era(e is the result of $orrowin( and incurrin( fi+ed o$li(ations for interest and principal payments. The owners of a successful $usiness that re!uires funds may not want to dilute their ownership of the $usiness $y issuin( additional e!uity. Instead* they can Ftrade on the e!uityF $y $orrowin( the funds re!uired* usin( their e!uity capital as a $orrowin( $ase. 5inancial le"era(e is ad"anta(eous when the rate of return on total assets e+ceeds the net after%ta+ interest cost paid on de$t. An additional ad"anta(e pro"ided $y financial le"era(e is that interest e+pense is ta+ deducti$le while di"idend payments are not. ??. #e"era(e is a two%ed(ed sword. In (ood times* net income $enefit from le"era(e. In a recession or when une+pected ad"erse e"ents occur* net income can $e harmed $y le"era(e. Therefore* the use of le"era(e is accepta$le to the financial mar'ets only up to some undefined le"el. /inety percent is hi(her than that =accepta$le> le"el. ,pecifically* at G0 percent de$t to total capital* future financin( fle+i$ility would $e e+tremely limited* lenders would not loan money* and e!uity financin( may cost more than the potential returns on incremental in"estments. Also* a G0 percent de$t le"el would ma'e net earnin(s e+tremely "olatile* with a si8a$le increase in fi+ed char(es. The incremental cost of $orrowin(* includin( refundin( of maturin( issues* increases with the le"el of $orrowin(. A G0 percent de$t le"el could pose the pro$a$ility of default and recei"ership in the e"ent that somethin( (oes wron(. The financial ris' of such a company would $e much too hi(h for either stoc'holders or $ondholders. ?@. In an analysis of deferred income ta+es* the analyst must reco(ni8e that under normal circumstances the deferred ta+ lia$ilities will =re"erse> 2$ecome paya$le4 only when a firm shrin's in si8e. ,hrin'a(e in firm si8e is usually accompanied with losses instead of with ta+a$le income. In such circumstances* the =drawin( down> of the deferred ta+ account is more li'ely to in"ol"e credits to ta+ loss carryforwards or carry$ac's* rather than to the cash account. To the e+tent that a future re"ersal is only a remote possi$ility* the deferred credit should $e "iewed as a source of lon(%term fundin( and $e classifia$le as part of e!uity. )n the other hand* if the possi$ility of a drawin( down of the deferred ta+ account in the foreseea$le future is hi(h* then the account* or a portion of it* is more in the nature of a lon(%term lia$ility.
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Chapter 10 - Credit Analysis
?. The accountin( re!uirements for the capitali8ation of leases are not ri(orous and definite enou(h to insure that all leases that represent* in effect* installment purchases of assets are capitali8ed. Conse!uently* the analyst must e"aluate leases that ha"e not $een capitali8ed with a "iew to includin( them amon( de$t o$li(ations. #eases which co"er most 2say %D0 percent4 of the useful life of an asset can (enerally $e considered the e!ui"alent of de$t financin(. 2,ee Chapter ? for additional analysis and discussion.4 ?B. )ff%$alance%sheet financin( are attempts $y mana(ement to structure transactions in such a way as to e+clude de$t 2and related assets4 from the $alance sheet. This is usually accomplished $y emphasi8in( le(al 2accountin(4 form o"er su$stance. E+amples of such transactions are ta'e or pay contracts* certain sales of recei"a$les* and in"entory repurchase a(reements. ?. 9ension accountin( reco(ni8es that if the fair "alue of pension assets falls short of the accumulated pension $enefit o$li(ation* a lia$ility for pensions e+ists. owe"er* this lia$ility normally does not ta'e into consideration the projected $enefit o$li(ation that reco(ni8es an estimate for future pay increases. When pension plans $ase their $enefits on future pay formulas* the analysts* who jud(e such understatement as serious and who can estimate it* may want to adjust the pension lia$ility for analysis purposes. ?D. The preferred method of presentin( the financial statements of a parent and its su$sidiary is in consolidated format. This is also the preferred method from an analysis point of "iew. owe"er* separate financial statements of the consolidated entities are necessary in some cases* such as when the utili8ation of assets of a su$sidiary 2such as an insurance company or a $an'4 is not su$ject to the full discretion of the parent. Information on unconsolidated su$sidiaries is also important when $ondholders of such su$sidiaries must loo' only to a su$sidiary
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Chapter 10 - Credit Analysis
li'ely to $e con"erted into common stoc'* it should $e considered as e!uity for the purpose of capital structure analysis.
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Chapter 10 - Credit Analysis
e. ost preferred stoc' entails no a$solute o$li(ation for payment of di"idends or repayment of principal-that is* it possesses characteristics of e!uity. owe"er* preferred stoc' with a fi+ed maturity or su$ject to sin'in( fund re!uirements should* from an analysis point of "iew* $e considered as de$t. @0. a. The e!uity of a company is measured $y the e+cess of total assets o"er total lia$ilities. Accordin(ly* any analytical re"ision of asset $oo' "alues 2from amounts reported at in the financial statements4 yields a chan(e in the amount of e!uity. 5or this reason* in assessin( capital structure* the analyst must decide whether or not the $oo' "alue amounts of assets are realistically stated in li(ht of analysis o$jecti"es. $. The followin( are e+amples of the need for possi$le adjustments. 6ifferent or additional adjustments may $e needed dependin( on circumstances 214 In"entories carried at #I5) are (enerally understated in times of risin( prices. The amount $y which in"entories computed under 5I5) 2which are closer to replacement cost4 e+ceed in"entories computed under #I5) is disclosed as the #I5) reser"e. These disclosures should ena$le the analyst to adjust in"entory amounts and the correspondin( e!uity amounts to more realistic current costs. 274 5or fiscal years $e(innin( $efore 17H1BHG?* mar'eta$le securities were (enerally stated at cost* which may $e $elow mar'et "alue. sin( parenthetical or footnote information* the analyst can ma'e an analytical adjustment increasin( this asset to mar'et "alue and increasin( owner&s e!uity $y an e!ual amount. 2?4 Intan(i$le assets and deferred items of du$ious "alue* which are included on the asset side of the $alance sheet* ha"e an effect on the computation of the total e!uity of a company. To the e+tent that the analyst cannot e"aluate or form an opinion on the present "alue or future utility of such assets* they may $e e+cluded from consideration* there$y reducin( the amount of e!uity $y the amounts at which such assets are carried. owe"er* the ar$itrary e+clusion of all intan(i$le assets from the capital $ase is an unjustified e+ercise in o"er%conser"atism. @1. #on(%term creditors are interested in the future operations and cash flows of a de$tor 2in addition to the short%term financial condition of the de$tor4. 5or e+ample* a creditor of a three%year loan would want to ma'e an analysis of sol"ency assumin( the worst set of economic and operatin( conditions. 5or such purposes* an analysis of short%term li!uidity is usually not ade!uate. owe"er* such a dynamic analysis for the lon( term is su$ject to su$stantial uncertainties and re!uires assumptions for a much lon(er time hori8on. The ine"ita$le lac' of detail and the uncertainties inherent in lon(%term projections se"erely limit their relia$ility. This does not mean that lon(%term projections are not useful. What it does mean is that the analyst must $e aware of the serious limitations to which they are su$ject. @7. Common%si8e analysis focuses on the composition of the funds that finance a company. As such* it reflects on the financial ris' inherent in the capital structure. ,pecifically* it shows the relati"e ma(nitudes of the financin( sources of the company and allows the analyst to compare them with similar data of other companies. Instead* capital structure ratios reflect on the financial ris' of a company $y relatin( "arious components of the capital structure to each other or to total financin(. An ad"anta(e of ratio analysis is that it can $e used as a screenin( de"ice and* moreo"er* can reflect on relations across more than one financial statement.
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Chapter 10 - Credit Analysis
@?. The difference $etween the $oo' "alue of e!uity capital and its mar'et "alue is usually due to a num$er of factors. )ne of these is the effect of price%le"el chan(es. These* in turn* are caused $y at least two factors chan(e in the purchasin( power of money and chan(e in price due to economic factors such as the law of supply and demand. Therefore* with fluctuatin( prices* it is unli'ely that historical cost will correspond to mar'et "alue. Accountin( methods in use can also si(nificantly affect the $oo' "alues of assets. 5or e+ample* a particular depreciation method often is adopted for ta+ reasons rather than to measure the loss of "alue of an asset due to use or o$solescence. The analyst could potentially adjust for this distortion of current "alue $y "aluin( the e!uity at mar'et "alue. 5or acti"ely traded securities this would not $e too difficult. owe"er* the stoc' mar'et too is often su$ject to su$stantial o"er"aluation and under"aluation dependin( on the de(ree of speculati"e sentiment. ence* in most cases* e!uity capital will not $e adjusted to mar'et-instead* the focus will $e on "aluin( assets and lia$ilities* with e!uity as a residual "alue. @@. ,ince lia$ilities and e!uity re"eal the financin( sources of a company* and the asset side re"eals the in"estment of these funds* we can (enerally esta$lish direct relations $etween asset (roups and selected items of capital structure. This does not* of course* imply that resources pro"ided $y certain lia$ilities or e!uity should $e directly associated with the ac!uisition of certain assets. ,till* it is "alid to assume that the types of assets a company employs should determine to some e+tent the sources of resources used to finance them. Therefore* to help assess the ris' e+posure of a (i"en capital structure* the analysis of asset distri$ution is one important dimension. As an e+ample* if a company ac!uired lon(%term assets $y means of short%term $orrowin(s* the analyst would conclude that this particular method of financin( in"ol"es a considera$le de(ree of ris' 2and cost4. @. The earnin(s to fi+ed char(es ratio measures directly the relation $etween de$t%related and other fi+ed char(es and the earnin(s a"aila$le to meet these char(es. It is an e"aluation of the a$ility of a company to meet its fi+ed char(es out of current earnin(s. Earnin(s co"era(e ratios are superior to other tools* such as de$t% to%e!uity ratios* which do not focus on the a"aila$ility of funds. This is $ecause earnin(s co"era(e ratios directly measure the a"aila$ility of funds for payment of fi+ed char(es. 5i+ed char(es are mainly a direct result of the incurrence of de$t. An ina$ility to pay their associated principal and interest payments represents the most serious ris' conse!uence of de$t. @B. Identifyin( the items to include in Ffi+ed char(esF depends on the purpose of the analysis. 5i+ed char(es can $e defined narrowly to include only interest and interest e!ui"alents or $roadly to include all outlays re!uired under contractual o$li(ationsspecifically 2a4 Interest and interest e!ui"alents i. Interest on lon(%term de$t 2includin( amorti8ation of any discounts and premiums4. ii. Interest element included in lon(%term lease rentals. iii. Capitali8ed interest. 2$4 )ther outlays under contractual o$li(ations i. Interest on income $onds 2assumin( profita$le operations-implicit assumption in such $orrowin(s4. ii. Re!uired deposits to sin'in( funds and principal payments under serial $ond o$li(ations. iii. 9rincipal repayments included in lease o$li(ations.
10-16
Chapter 10 - Credit Analysis
i". 9urchase commitments under noncancela$le contracts to the e+tent that re!uirements e+ceed normal usa(e. ". 9referred stoc' di"idend re!uirements of majority%owned su$sidiaries. "i. Interest on recorded pension lia$ilities. "ii. Kuarantees to pay fi+ed char(es of unconsolidated su$sidiaries if the re!uirement to honor the (uarantee appears imminent. 2c4 )ther fi+ed char(es-such as imputed interest in the case on non%interest or low interest%$earin( o$li(ations. These are not periodical fund drains. 5or each of the a$o"e cate(ories* the correspondin( income to $e included in the ratio computation should $e adjusted accordin(ly. Re(ardin( fi+ed char(es* those items not ta+ deducti$le must $e ta+ adjusted. This is done $y increasin( them $y an amount e!ual to the income ta+ that would $e re!uired to o$tain an after%ta+ income sufficient to co"er the fi+ed char(es. The ta+ rate to $e used should $e $ased on the relation of the ta+es on income from continuin( operations to the amount of pre%ta+ income from continuin( operations-the company&s effecti"e ta+ rate . @. A company normally si(ns a lon(%term purchase contract to either insure that its supply of essential raw material is not interrupted or to (et a fa"ora$le purchase discount* or $oth. In times of fa"ora$le economic conditions* the analyst need not worry a$out most such commitments 2indeed* they are a positi"e factor4. The only e+ception is when such commitments reflect amounts in e+cess of re!uirements (i"en e+pected sales. Accordin(ly* if the analyst concludes that the purchase commitments represent the minimum re!uired supplies* sHhe can justifia$ly e+clude the commitments from fi+ed char(es. If the analyst includes the commitments in fi+ed char(es* income should $e adjusted to reflect the ta+%deducti$le nature of the purchase that will e"entually $e recorded as cost of (oods sold. 9roceeds from the forced sale of e+cess supplies can also $e deducted on an estimated $asis. @D. /et income includes items of re"enue that do not (enerate immediate cash. It also includes e+penses that do not re!uire the immediate use of cash. 5or a measure of cash a"aila$le to meet fi+ed char(es* the more rele"ant fi(ure is Fcash pro"ided $y operationsF reported in the statement of cash flows. /et income can sometimes $e used as a pro+y of this more appropriate measure of cash a"aila$ility. @G. ,ince Company is under the control of Company A* the latter can siphon off funds from it to the detriment of &s creditors. oreo"er* the customer%supplier relationship with Company A means that Company A has considera$le discretion in the allocation of re"enues* costs* and e+penses amon( the two entities in such a way as to determine which company will show what portion of the total a"aila$le income. This a(ain can wor' to the detriment of Company &s creditors. As a lender to Company * one would want to write into the lendin( a(reement conditions that would pre"ent parent Company A from e+ercisin( its controllin( powers to the detriment of the lender. 0. 6e$t can ne"er $e e+pected to carry the ris's and returns of ownership $ecause of the fi+ed nature of its rewards. Also* it cannot ser"e as the permanent ris' capital of a company $ecause it must $e repaid with interest. oreo"er* de$t is incurred on the foundation of an e!uity $ase. Indeed* e!uity financin( shields or at least reduces the ris's of de$t financin(. E!uity financin( also a$sor$s the losses to which a company is e+posed. Conse!uently* the assertion is $asically accurate.
10-17
Chapter 10 - Credit Analysis
1. The ad"anta(es of con"erti$le de$t are that the company is a$le to potentially enlar(e its e!uity $ase 2andHor at a potentially lower cost4 than it mi(ht otherwise $e a$le to with pure e!uity financin(. Also* it mi(ht $e a$le to sell e!uity shares at a price in e+cess of the current mar'et price and to o$tain* in the interim* a lower interest cost $ecause of the con"ersion feature of the de$t. The disad"anta(es are that a su$se!uent decline in the mar'et price of the stoc' can postpone con"ersion su$stantially and indefinitely. This would lea"e the company with a de$t $urden that it was not prepared to shoulder o"er the lon( term. Conse!uently* what may ha"e $een concei"ed of as temporary financin( can* in fact* $ecome lon(%term de$t financin(. 7. 2a4 #on(%term indentures span such an e+tended period of time that they are su$ject to many uncertainties and impondera$les. Conse!uently* lon(%term creditors often insist on the maintenance of certain ratios at specified le"els andHor controls o"er specific mana(erial actions and policies 2such as di"idends and capital e+penditures4. owe"er* no restricti"e co"enant or other contractual arran(ement can pre"ent operatin( losses* which present the most serious ris' to lon(%term creditors. 2$4 1. aintenance of a minimum de(ree of short%term li!uidity. 7. 9re"ention of the dissipation of e!uity capital $y retirement* refundin(* or the payment of e+cessi"e di"idends. ?. 9reser"ation of e!uity capital for the safety of creditors. @. Insure the a$ility of creditors to protect their interests in a deterioratin( situation. ?.
The major reason why de$t securities are rated while e!uity securities are not rest in the fact that there is a far (reater uniformity of approach and homo(eneity of analytical measures used in the e"aluation of credit worthiness than there is in the e"aluation of e!uity securities. This increased a(reement on what is $ein( measured in credit ris' analysis has resulted in widespread acceptance of and reliance on pu$lished credit ratin(s in many sectors of the analyst community.
@. In ratin( an industrial $ond issue* ratin( a(encies focus on the issuin( company&s asset protection* financial resources* earnin( power* mana(ement* and the specific pro"isions of the de$t security. Asset protection is concerned with measurin( the de(ree to which a company&s de$t is co"ered $y its assets. 5inancial resources encompass* in particular* such li!uid resources as cash and other wor'in( capital items. 5uture earnin( power is a factor of (reat importance in the ratin( of de$t securities $ecause the le"el and the !uality of future earnin(s determine importantly a company&s a$ility to meet its o$li(ations. Earnin(s power is (enerally a more relia$le source of security than is asset protection. ana(ement a$ilities* philosophy* depth* and e+perience always loom importantly in any final ratin( jud(ment. Throu(h inter"iews* field trips and other analyses the raters pro$e into mana(ement&s (oals* the plannin( process as well as strate(ies in such areas as research and de"elopment* promotion* new product plannin( and ac!uisitions. The specific pro"isions of the de$t security are usually spelled out in the $ond indenture.
10-18
Chapter 10 - Credit Analysis
. The analyst who can effecti"ely e+ecute financial statement analysis can also impro"e on the pu$lished $ond ratin(s. Indeed* effecti"e financial statement analysis is possi$ly e"en more "alua$le in the "aluation of de$t securities than in the case of e!uity securities. ond ratin(s co"er a wide ran(e of characteristics and they present opportunities for those who can $etter identify 'ey differences within a ratin( classification. oreo"er* ratin( chan(es (enerally la( the mar'et. This la( presents additional opportunities to an analyst who with superior s'ill and alertness can identify important chan(es $efore they $ecome (enerally reco(ni8ed.
B. Companies hire $ond%ratin( a(encies to rate their de$t $ecause these ratin(s are an e+ternally (enerated* independent si(nal of the company&s creditworthiness and !uality. In"estors would rely less on ratin(s if they were produced in%house $ecause of mana(ement&s incentives to report hi(h !uality and of mana(ement self%interest. In short* they act as independent si(nals of de$t !uality.
10-19
Chapter 10 - Credit Analysis
ELERCI,E, E+ercise 10%1 270 minutes4 Current Ratio 1.M /o chan(e 7. /o chan(e ?. Increase @. 6ecrease . 6ecrease B. 6ecrease . Increase D. 6ecrease G. Increase 10. /o chan(e
3uic' Ratio /o chan(e /o chan(e Increase /o chan(e 6ecrease 6ecrease Increase 6ecrease Increase 6ecrease
Wor'in( Capital /o chan(e /o chan(e Increase 6ecrease 6ecrease 6ecrease /o chan(e /o chan(e Increase /o chan(e
M Assumes a sufficient amount is pro"ided for in the Allowance for ad 6e$ts.
E+ercise 10%7 2?0 minutes4 1.
2a4 2$4 /E /E
2c4 6
;ournal Entry C)K, 00 R.E. 00
7.
I
6
/E
Accts Rec$le ,ales
?.
I
6
/E
Allow for ad 6e$ts Accts Rec$le
@.
I
6
/E
ad 6e$t E+pense Accts Rec$le
.
/E /E
I
C)K, In"entory
B.
/E /E
I
R.E. 00 C)K, 00
E+planation Cost of (oods sold increases $y 00N a"era(e in"entory increases $y 70N ratio 2c4 decreases. 6enominator will increase $y half the amount of the numerator causin( the 2a4 ratio to increase. 6enominator of ratio 2$4 will increase causin( the ratio to decrease. There is no effect on the components of ratio 2c4. The numerator in ratio 2a4 won&t chan(e and the denominator will decrease thus increasin( the ratio. ecause ratio 2a4 will increase* ratio 2$4 will decrease as the a"era(e accounts recei"a$le turno"er increases. Ratio 2c4 is unaffected. Ratio 2a4 will increase due to the decrease in the denominator. Ratio 2$4 will decrease due to the increase in the denominator* which is due to the increase in ratio 2a4. Ratio 2c4 is unaffected. )nly ratio 2c4 is affected. The numerator increases while the denominator decreases. /either ratio 2a4 nor 2$4 are affected. The a"era(e in"entory will decrease $y 0O of the decrease in the numerator in ratio 2c4 due to the a"era(in( effect* thus increasin( the ratio.
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Chapter 10 - Credit Analysis
E+ercise 10%? 2?0 minutes4 1.
2a4 2$4 /E /E
2c4 /E
;ournal Entry Allow for ad 6e$ts Accts Rec$le
E+planation ,ince we use the net A.R. in computation of ratio* there is no effect.
7.
/E /E
6
C)K, R.E.
/either ratio 2a4 nor 2$4 is affected. The cost of (oods sold increases $y P1*000* and a"era(e in"entory will increase $y P00 2due to the a"era(in( effect4* thus decreasin( ratio 2c4.
?.
/E /E
I
C)K, In"entory
)nly ratio 2c4 is affected. The numerator increases while the denominator decreases.
@.
/E /E
I
#oss In"entory
/either ratio 2a4 nor 2$4 is affected. A"era(e in"entory will decrease $y P1*00 2half of P?*0004* increasin( ratio 2c4.
.
/E /E
I
R.E. C)K,
/either ratio 2a4 nor 2$4 is affected. The a"era(e in"entory will decrease $y half of the decrease in the numerator.
B.
I
/E
,ales Accts Rec$le
6enominator of ratio 2a4 decreases $y half the amount the numerator decreases* causin( ratio 2a4 to increase. 6enominator of ratio 2$4 will increase* causin( it to decrease. There is no effect on ratio 2c4.
6
E+ercise 10%@ 2@ minutes4 a. ethods to window dress financial statements to impro"e the current and !uic' ratios 1. 9ay off accounts paya$le with cash. This would ha"e the effect of reducin( $oth current assets and current lia$ilities $y the same amount* thus increasin( the current ratio and !uic' ratio. 7.M In"est additional capital funds at year%end. This would increase cash without affectin( current lia$ilities. ?.M ,ell fi+ed assets for cash or short%term notes. This would increase current assets* $ut decrease only fi+ed assets. Thus* the current and !uic' ratios would impro"e. @.M orrow cash $y incurrin( lon(%term lia$ilities 2notes or $onds4. This would increase cash* $ut would not affect current lia$ilities* since the purpose is to ma'e them lon(%term lia$ilities. .M 6efer incurrin( "arious e+penses* such as ad"ertisin(* research and de"elopment* and mar'etin(* alon( with reducin( capital e+penditures. B. Jeep the cash receipts $oo's open lon(er* in an effort to show hi(her recei"a$les or collections. This method is a hi(hly irre(ular and manipulati"e de"ice. M
These procedures are normal $usiness transactions that cannot usually $e considered manipulati"e in character. They may $ecome manipulati"e when they ha"e no sound $usiness justification and are underta'en solely to influence the measures used $y outside analysts.
10-21
Chapter 10 - Credit Analysis
E+ercise 10%@-concluded $. The analyst could* if all underlyin( e"idence and documents were a"aila$le* detect each of these methods. owe"er* sufficient e"idence* such as in"oices and the $oo's of ori(inal entry* will most li'ely not $e a"aila$le for inspection. oreo"er* these methods may not $e reco(ni8a$le throu(h the usual analysis of financial statements of the company. If sufficient e"idence were a"aila$le* the followin( are techni!ues that may $e used to detect the methods descri$ed in a. 1. The analyst could determine the company&s usual payment policies* and compare them with those employed at year%end. ,Hhe could loo' at the terms of the lia$ilities* to see if they were paid at the most $eneficial time-in other words* if any economic $enefit was deri"ed $y payin( them earlier than due or when normally paid. ,Hhe could inspect the payments in the first month of the followin( year* to see if lia$ilities were paid disproportionately to year%end* ta'in( into account due dates and normal re!uirements. An unusually low in"entory at year%end mi(ht also indicate failure to purchase merchandise at year%end in an effort to impro"e the !uic' ratio. 7. The analyst could analy8e the timin( of in"estments and the use to which they were put. If sHhe sees lar(e capital infusions at year%end* and that these in"estments were represented $y idle cash* or $y mar'eta$le securities which are not related to operations* and where there is little pro$a$ility of such funds $ein( re!uired for operations in the near future* the reason mi(ht $e window dressin(. ?. Contracts and in"oices mi(ht $e e+amined to see when they were entered into and when they were recorded. @. The procedures for in"esti(ation of e+cessi"e $orrowin( at year%end are the same as those for e+cessi"e in"estments of e!uity funds 27. a$o"e4. Also* the contracts should $e studied to determine if they are $ona fide loans. . The purchase journal and cash dis$ursements journal should $e e+amined to compare e+penses incurred towards the end of the year with e+penses at the $e(innin( of the followin( year* and the reasons for lar(e differences. B. To determine if the $oo's are $ein( 'ept open too lon(* the analyst would study such documents as the underlyin( in"oices and canceled chec's to determine their actual dates* and to compare this with the dates recorded. ,Hhe mi(ht also confirm material accounts with customers as of the year%end.
10-22
Chapter 10 - Credit Analysis
E+ercise 10% 2?0 minutes4 AM
M
CM
6M
1.
/E
/E
IHIQ6
IHIQ6
7.
6H/EQ6
6H/EQ6
6H6QI
6H6QI
?.
IH/EQI
IH/EQI
IHIQ6
IHIQ6
@.
/EHIQ6
/EHIQ6
IHIQ6
IHIQ6
.
/E
/E
6H/EQ6
/E
B.
/E
/E
/E
IH/EQI
.
/E
/E
IHIQ6
IHIQ6
D.
/E
/E
6H6QI
6H6QI
G.
6HIQ6
6HIQ6
/E
/E
10.
IH/EQI
/E
/E
/E
M
Ratio codes and definitions A. Total de$t H Total e!uity . #on(%term de$t H Total e!uity C. 9re%ta+ earnin(s S 5i+ed char(es 25C4 H 5C 6. 9reta+ C5) S 5C H 5C
E+ercise 10%B 27 minutes4 I. $ II. a III. $ IV. $ V. d
10-23
Chapter 10 - Credit Analysis
9R)#E, 9ro$lem 10%1 2B0 minutes4 a. ,hort%term li!uidity ratios for Camp$ell ,oup 1. ?B H @ Q P1*BB. H P1*7GD.1 Q 1.7D 7. 2PD0. ?1 S P77. ?7 S PB7@. ??4 H P1*7GD.1 @ Q 0.B ?. PB*70.D 1? H 2PB7@. ?? S P[email protected] Q 10.@@ @. P@*7D.7 1@ H 2PD1G.D ?@ S PD1B.04H7 Q .71 . PB7@. ?? H 2PB*70.D H ?B04 Q ?B.7? B. PD1G.D H 2P@*7D.7 H ?B04 Q BG.?1 . ?B.7? S BG.?1 Q 10.@ D. 2PD0. S P77.4 H P1*BB. Q 0.0B7 G. 2PD0. S P77.4 H P1*7GD.1 Q 0.0G 10. Endin( in"entoryUUUUUUUU SCost of (oods soldUUUUUUU. % e(innin( in"entory.UUUUUU. % 6epreciationUUUUUUUUUU. Q9urchases.UUUUUUUUUUU
P D1G.D ?@ @*7D.7 1@ D1B.0 2(i"en4 [email protected] 1D P@*0.G
2P7.7 @1 H 2P@*0.G H ?B04 Q @B.?B 11. 10.@ % @B.?B Q G.1D 17. P@@D.@ B@ H P1*7GD.1 @ Q ?@.@O $. Camp$ell
10-24
Chapter 10 - Credit Analysis
9ro$lem 10%1-concluded c. Current assets usin( 5I5) Q P1*BB. ?B S [email protected] 1? Q P1*0.1 C)K, 25I5)4 Q C)K, 2#I5)4 S #I5) reser"e Q P@*7D.7 S [email protected] % 2PG0@ % PD1B4 Q P@*7@.D 1. P1*0.1 H P1*7GD.1 Q 1.? @. P@*7@.D H 2PG0@.@ S PG0@4H7 Q @.1 . PB7@. ?? H 2PB*70.D 1? H ?B04 Q ?B.7? B. PG0@.@ H 2P@*7D.7 H ?B04 Q B.@B . ?B.7? S B.@B Q 117.BG d. 6isre(ardin(* for purposes of this analysis* the prepaid e+penses and similar unsu$stantial items enterin( the computation of the current ratio* we are left with the four major elements that comprise this ratio-those are cash* accounts recei"a$le* in"entories* and current lia$ilities. If we define li!uidity as the a$ility to $alance re!uired cash outflows with ade!uate inflows* includin( an allowance for une+pected interruptions of inflows or increases in outflows* we must as' 6oes the relation of these four elements at a (i"en point in time 1. easure and predict the pattern of future fund flows 7. easure the ade!uacy of future fund inflows in relation to outflows nfortunately* the answer to $oth of these !uestions is primarily no. The current ratio is a static concept of what resources are a"aila$le at a (i"en moment in time to meet the o$li(ations at that moment. The e+istin( reser"oir of net funds does not ha"e a lo(ical or causal relation to the future funds that will flow throu(h it. :et it is the future flows that are the su$ject of our (reatest interest in the assessment of li!uidity. These flows depend importantly on elements not included in the ratio itself* such as sales* profits* and chan(es in $usiness conditions. There are at least three conclusions that can $e drawn 1. #i!uidity depends to some e+tent on cash or cash e!ui"alents $alances* $ut to a much more si(nificant e+tent on prospecti"e cash flows. 7. There is no direct or esta$lished relation $etween $alances of wor'in( capital items and the pattern that future cash flows are li'ely to assume. ?. ana(erial policies directed at optimi8in( the le"els of recei"a$les and in"entories are mainly directed towards efficient and profita$le asset utili8ation and only secondarily towards li!uidity. These conclusions o$"iously limit the "alue of the current ratio as an inde+ of li!uidity. oreo"er* (i"en the static nature of this ratio and the fact that it consists of items that affect li!uidity in different ways* we must e+ercise caution in usin( this ratio as a measure of li!uidity.
10-25
Chapter 10 - Credit Analysis
9ro$lem 10%1-concluded e. Accounts recei"a$le turno"er rates or collection periods can $e compared to industry a"era(es or to the credit terms (ranted $y the company. When the collection period is compared with the terms of sale allowed $y the company* the de(ree to which customers are payin( on time can $e assessed. In assessin( the !uality of recei"a$les* the analyst should remem$er that a si(nificant con"ersion of recei"a$les into cash* e+cept for their use as collateral for $orrowin(* cannot $e achie"ed without a cut$ac' in sales "olume. The sales policy aspect of the collection period e"aluation must also $e 'ept in mind. A company may $e willin( to accept slow%payin( customers who pro"ide $usiness that is* on an o"erall $asis* profita$leN that is* the profit on sale compensates for the e+tra use $y the customer of the company funds. This circumstance may modify the analyst&s conclusions re(ardin( the quality of the recei"a$les $ut not those re(ardin( their liquidity . The current ratio computation "iews its current asset components as sources of funds that can* as a means of last resort* $e used to pay off the current lia$ilities. Viewed this way* the in"entory turno"er ratios (i"e us a measure of the !uality as well as of the li!uidity the in"entory component of the current assets. The !uality of in"entory is a measure of the company&s a$ility to use it and dispose of it without loss. When this is en"isa(ed under conditions of forced li!uidation* then reco"ery of cost is the o$jecti"e. In the normal course of $usiness* the in"entory should* of course* $e sold at a profit. Viewed from this point of "iew* the normal profit mar(in reali8ed $y the company assumes importance $ecause the funds that will $e o$tained* and that would theoretically $e a"aila$le for payment of current lia$ilities* will include the profit in addition to the reco"ery of cost. In $oth cases* costs of sales will reduce net proceeds. In practice* a (oin( concern cannot use its in"estment in in"entory for the payment of current lia$ilities $ecause any drastic reduction in normal in"entory le"els will surely cut into the sales "olume. The turno"er ratio is a (au(e of li!uidity in that it con"eys a measure of the speed with which in"entory can $e con"erted into cash. In this connection* a useful additional measure is the con"ersion period of in"entories.
10-26
Chapter 10 - Credit Analysis
9ro$lem 10%7 2@ minutes4 5uture Technolo(ies* Inc. Cash 5orecast 5or :ear Ended 6ecem$er ?1* :ear 7 Cash* ;anuary 1* :ear 7 P @7*000
Cash Collections Accounts recei"a$le* ;an. 1*:ear 7 ,alesM #ess discount on sales a #ess acct. rec.* 6ec. ?1* :ear 7 $ Total cash a"aila$le
P G0*000 @7*00 B7*00 2G@4 27*1DD4
@DG*?B ?1*?B
Cash 6is$ursements Accounts paya$le* ;an 1.* :ear 7 9urchases c #ess Acct. pay.* 6ec. ?1* :ear 7 d Accrued ta+es paid )ther e+penses-Cash e Cash a"aila$le* 6ec. ?1* :ear 7
D*000 ?B*B0 21?7*114
?07*7@G 10*D00 11B*0
Cash needed for e!uipment Cash $alance desired 6eficiency in Cash 2need to $orrow4
@7G*GG P 101*BD 21*0004 2?0*0004 P210?*7?74
M
,ales P@0*000 + 1.0 Q P@7*00 Cost of (oods sold P?17*000 + .GD Q P?0*B0
a
P@7*00 + 10O + 7O Q PG@ 2discount on sales4
$
P@7*00 + G0O + 2B0H?B04 Q P0*D P@7*00 + 10O + 210H?B04 Q 1*?1? P7*1DD 2Accounts recei"a$le* 6ec. ?1* :ear 74
c :ear 7 Cost of (oods sold..UUUU... Endin( in"entoryUUUUUUUUU.. Koods a"aila$le for sale.UUUUU... e(innin( in"entoryUUUUUUUU 9urchasesUUUUUUUUUUUU..
P?0*B0 G0*000 2(i"en4 P?G*B0 ?G*000 P?B*B0
d
Accounts 9ay.* 17H?1H:ear 7 Q :r 7 9urchases + 2A.9.* 17H?1H:ear 1 H :r 1 9urchases4 Accounts 9ay.* 17H?1H:ear 7 Q P?B*B0 + 2PD*000 H P710*0004 Q P1?7*11
e
:ear 1 ,alesUUUUUUUUUUUU P @0*000 U Cost of (oods soldUUUUUU. 2?17*0004 6epreciationUUUUUUUUU. 21*0004 . /et 217*0004 incomeUUUUUUUUUU. )ther P 111*000 e+pensesUUUUUUUU )ther e+penses 2:ear 74 Q P111*000 + 1.0 Q P11B*0
10-27
Chapter 10 - Credit Analysis
9ro$lem 10%? 2@ minutes4 RA Corporation Cash 5orecast $efore 9olicy Chan(es 5or :ear Ended 6ecem$er ?1* :ear 7 Cash* ;anuary 1* :ear 7UUUUUUUU Cash Collections Accounts recei"a$le* ;an. 1UUUU ,ales 2D00*000 + 110O4UUUUUU. #ess Accounts rec$le.* 6ec. ?1 a.. Total cash a"aila$le UUUUUUUUU.. Cash 6is$ursements Accounts paya$le* ;an. 1UUUUU. P1?0*000 9urchases $UUUUUUUUUU.. B*000 #ess Accounts pay.* 6ec. ?1 cU... 27@@*0004 Increase in notes paya$leUUUU... Accrued ta+esUUUUUUUUUU. Cash e+penses dUUUUUUUU. /et cash flowUUUUUUUUUUUU...
P10*000 DD0*000 21B*0004
P D0*000
DB*000 G@*000
@?*000 21*0004 70*000 7D*00
Cash $alance desiredUUUUUUUUU Cash e+cessUUUUUUUUUUUUU.
D0B*00 P1?D*00 0*000 P DD*00
/otes a ?B0 days H 2PD00*000HP10*0004 Q B. days Applied to :ear 7 sales PDD0*000 + 2B.H?B04 Q P1B*000 $ :ear 7 Cost of sales 2P70*000 + 110O4UUUUUU P7*000 Endin( in"entory 2(i"en4UUUUUUUUUUU 10*000 Koods a"aila$le for saleUUUUUUUUUUU 77*000 e(innin( in"entoryUUUUUUUUUUUUU B*000 9urchasesUUUUUUUUUUUUUUUUU.. PB*000 c
9urchases + 2:ear 1 Accounts paya$le H :ear 1 9urchases4 Q PB*000 + 2P1?0*000 H P?0*0004 Q P7@@*000
d
Kross profit 2PDD0*000 % P7*0004UUUUUUUU P?0D*000 #ess /I 2110O of P70*000 :ear 1 /I4 S 210O of :ear 1 depreciationM4 2P77*000 S P7*004U P7@*00 6epreciation noncashUUUUUUUUUUUU.. 7*000 @G*00 )ther cash e+penses P7D*00 M 6epreciation e+pense is not e+pected to increase $y 10O.
10-28
Chapter 10 - Credit Analysis
9ro$lem 10%?-concluded a.
What%If Analysis of 9roposed Credit 9olicy Chan(e A.R.* 6ec. ?1 PDD0*000 2sales4 + 2G0H?B04 UU. #ess A.R. from forecast statement 2a$o"e4..... Additional cash neededUUUUUUUUUU Cash e+cess 2a$o"e4UUUUUUUU...UU.. Cash e+cess for this proposalUUUUUUU
P 770*000 1B*000 *000 DD*00 P ??*00
$. What%If Analysis of 9roposed Collection 9eriod Chan(e A.R.* 6ec. ?1 PDD0*000 2sales4 + 2170H?B04 UU #ess A.R. from statement 2a$o"e4UUUUU.. Additional cash neededUUUUUUUUUU. Cash e+cess 2a$o"e4UUUUUUUUUUU.. Cash to $e $orrowedUUUUUUUUUUU.. c.
P 7G?*000 1B*000 17D*000 DD*00 P ?G*00
What%If Analysis of 9roposed 9ayment 9eriod Chan(e A.9.* 6ec. ?1 PB*000 2purch.4 + 2B0H?B04U. A.9. from statement 2a$o"e4 UUUUUUUU... Additional cash neededUUUUUUUUUU Cash e+cess 2a$o"e4UUUUUUUUUUU. Cash to $e $orrowedUUUUUUUUUUU.
10-29
P10G*00 7@@*000 1?@*00 DD*00 P @B*000
Chapter 10 - Credit Analysis
9ro$lem 10%@ 2@0 minutes4
Top Corporation Cash 5orecast 5or :ear Ended 6ecem$er ?1* :ear B Cash $alance UUUUUU..
21H1H:ear
B4
P ?*000
Cash receipts Accounts recei"a$le* ;an. 1.. U...
P *000
,alesUUUUUUUUUUUU U.
@17*00
Accounts recei"a$le* 6ec. ?1 2,ales* P@17*00 + G0H?B04 UU.. Cash UUUUUUUU
210?*174
receiptsU.
Total a"aila$leUUUUUUUU...
?D@*?
cash
P@1G*?
Cash dis$ursements Accounts paya$le* UUU
;an. 1 . P B*000
9urchases UUUUUUUUU Accounts UUU
paya$le*
1 ??1*0 6ec.
9ayment of paya$leUUU.
?1 2177*0004
notes
7@*0 7*00
Accrued ta+esUUUUUUUUU Cash e+penses UUUUUUU Estimated $alanceUUUUUUU. inimum desiredUUU.
cash
Re!uired
G*000 7
110*70
?GB*00
cash
P 77*D
$alance
0*000
to
P 7*17
$orrowUUUUUUUUU. /otes 1 e(innin( in"entoryUUUUUUUU. S 9urchases (plug)UUUUUUUUU Koods a"aila$le for sale.UUUUUU. % Endin( in"entoryUUUUUUUUU.
P ?7*000 ??1*0 ?B?*0 *000
10-30
Chapter 10 - Credit Analysis
Cost of sales 2P@17*00 + .04UUUU
P7DD*0
Kross profit 2?0O of sales4UUUUUU 6epreciation 2P7*000 % P71*004UUU.. /et income 2e+cludes other e+penses4.. )ther e+penses 2plu(4UUUUUUU.U /et income 2(i"en4UUUUUUUUU...
P17?*0 ?*00 170*70 110*70 P 10*000
7
10-31
Chapter 10 - Credit Analysis
9ro$lem 10% 2B0 minutes4 a. Rele"ant information that pro$a$ly can $e deri"ed from the notes to the financial statements includes 1. 6etails of Kant&s $an' credit* includin( total line of credit* portion currently unused* interest rates* and terms of credit. 7. Impacts of any consolidated su$sidiaries on the li!uidity of the consolidated $alance sheet of Kant. ,u$sidiaries usually maintain separate credit facilitiesN therefore* sol"ency of a su$sidiary may not necessarily $e accessi$le to the parent company&s creditors. ?. Kant&s pension fundin( o$li(ations. Is there an unfunded lia$ility If so* what are the future financial o$li(ations Additional rele"ant information that you should attempt to o$tain from Kant&s mana(ement includes
@. 9rior years< 2andHor !uarterly4 statements of cash receipts and payments. . 5orecasts statement 2one or more years4 of due dates and amounts for its recei"a$les and paya$les. B. ud(et of planned capital e+penditures. . ud(et of planned lon(%term financin(. $. 3ualitati"e assessments that you would want to ma'e re(ardin( Kant Corporation and its industry include 1. 5inancial fle+i$ility of Kant in terms of its a$ility to li!uidate assets without affectin( profita$ility. 7. #e"el of inflation 2prices chan(es4 applica$le to Kant and its industry 2includin( those for raw materials* unioni8ed la$or* product price fle+i$ility4. ?. Kant&s competiti"eness in the domestic industry 2that is* how up%to%date is its plant and e!uipment4. Also* will major capital e+penditures $e re!uired in the near term @. ow does the industry and Kant compete internationally Are there ad"erse international industry de"elopments $eyond the control of Kant In addition to these (eneral !ualitati"e assessments of Kant* you would want to consider the followin( more specific !ualitati"e assessments
. Cost Control 9ro(ram ow has the cost cuttin( pro(ram impacted its financial fle+i$ility ow lean is its operations Are there assets that can $e disposed of without impactin( producti"ity or profita$ility ne(ati"ely as the pro(ram $een too intense such that lon(%term opportunities are lost B. FCommodityF )rientation of 9roduct #ine What has happened with commodity prices o"er the past se"eral years Are the mar'ets for Kant&s "arious product lines soft . .,. 9lant 5acilities ow has the stren(thHwea'ness in the .,. dollar affected the company&s competiti"e position o"er the past years ow competiti"e is Kant internationally Will it $e forced to di"ersify its operations internationally andHor up(rade plant producti"ity ow would a major sustained capital e+penditure pro(ram affect sol"ency
10-32
Chapter 10 - Credit Analysis
9ro$lem 10%B 2B0 minutes4 a. Ratio 1. Current ratio :ear PB1*000HP@0*000UUUUUU. :ear B PD@*000HP@*000UUUUUU.
:ear 1.
1.B
7. 6ays& sales in recei"a$les 2P70*000 H 2P1*000H?B04UUUU... B 2P7*000 H 2P1DB*000H?B04UUUU...
@B
?. In"entory turno"er PGG*000H2P?7*000SP?D*0004H7UU.. B P170*000H2P?D*000SPB*0004H7UU
7.D?
@. 6ays& sales in in"entory P?D*000H2PGG*000H?B04UUUUUU. B PB*000H2P170*000H?B04UUUUU..
1?D
. 6ays& purchases in accounts paya$le P7?*000H2P10*000M H?B04UUUUU B P7G*000H2P1?D*000M H?B04UUUUU
G
* Purchases
@D
7.
1BD
B Year 5
Cost of salesUUUUUUUU... S Endin( in"entoryUUUUUU Koods a"aila$le for saleUUU.. % e(innin( in"entoryUUUU... 9urchasesUUUUUUUUUU
Year 6
P GG*000 ?D*000 1?*000 ?7*000 P10*000
B. Cash flow ratio P*00 H P@0*000UUUUUUU.U. B PB*@00 H P@*000UUUUUUU.U.
:ear B
P170*000 B*000 1B*000 ?D*000 P1?D*000
0.1G 0.17
$. ost of the li!uidity measures of XETA do not re"eal any si(nificant chan(es from :ear to :ear B. owe"er* there is some deterioration in the in"entory turno"er. This deterioration is e"en more e"ident in the days& sales in in"entory measures. oreo"er* the li!uidity inde+ also su((ests that the li!uidity position of XETA has deteriorated from :ear to :ear B. Also notice that $ecause of a lower le"el of operatin( cash flows* the cash flow ratio shows a si(nificant decline. ,till* due to the short time span of this analysis* one would want to e+amine another year or two 2say* :ears ? and @4 to see if these chan(es reflect a lon(er%term trend in li!uidity.
10-33
Chapter 10 - Credit Analysis
9ro$lem 10% 2G0 minutes4 a. ,ummary of Ratio Analysis Results 700
1. #on(%term de$t to e!uity capital.......................
0.0D 2P0HPB*@D4
7. Total lia$ilities to total lia$ilities and e!uity....
0.7 2P1B*?0HP7?*714
?. Total lia$ilities to e!uity.....................................
7.D 2P1B*?0HPB*@D4
@. Cash from operations to lon(%term de$t..........
10.7 2P*?10HP04
. E!uity capital to 99E 2net4.................................
?.D@ 2PB*@DH1*BG14
$. 6ell
10-34
Chapter 10 - Credit Analysis
9ro$lem 10%D 2 minutes4 a. Computation of :ear 10 capital structure and sol"ency ratios for Camp$ell re!uires that we determine the followin( component measures for :ear 10 #on(%term de$t /otes paya$le................................................................... P G7.G Capital lease o$li(ations................................................. 17.G #on(%term de$t 17........................................................ D0.D 6eferred income ta+es 20O4 1B................................. 11.B )ther #ia$ilities 1....................................................... 7D. Current #ia$ilities @...................................................... 1*7GD.1 Total de$t........................................................................... P7*70.0 E!uity Capital )wners& e!uity @........................................................... P1*BG1.D 6eferred income ta+es 20O4 1B................................. 11.B inority interests 1D.................................................... B.? Total e!uity........................................................................ P1*DB. 1. P7*70.0 H P1*DB. Q 1.71 7. P7*70.0 H P@*11.B Q 0. ?. 2PD0.D S P11.B S P7D.4 H P1*DB. Q 0.1 @. P1*DB. H P7*70.0 Q 0.D? . P1*1. ? H P1*DB. Q 0.G7 B. P1*7GD.1 H P7*70.0 Q 0.D . /umerator
9reta+ income 7B..................................................... Interest e+pense 100................................................ Int. with oper. leases 21H? of PB7.@ 1@?4.................. Interest incurred GD.................................................. ndistri$uted e!uity in earnin(s in non% consolidated su$s. 1BGA 2P1?.0% P.@4.................. ?0B.7
1G.@ 111.B 70.D 2.B4 1@7.
6enominator
%% %% 70.D 171.G 0.0
Ratio Q P?0B.7 H P1@7. Q 7.1@ D. /umerator
Cash from ops $efore ta+M......................................... Interest e+pense ........................................................ Interest incurred ........................................................ Interest portion of op leases......................................
B1G. 111.B %% 70.D 1.G
M C5) B@ P@@D.@ S Current ta+ e+pense P11.1 17@A Q PB1G.
Ratio Q P1.G H P1@7. Q .7 G. P?B.@ H P7*70.0 Q 0.1B
10-35
6enominator
%% %% 171.G 70.D 1@7.
Chapter 10 - Credit Analysis
9ro$lem 10%D-concluded $. We would compute the total de$t to total capitali8ation as follows PD0A.D2a4 R@B P7D.A2$4 R1CC P1*0BG.@2d4 P1*BG1.D2e4 RA@
P7?A.12c4 R1CB PAB.? 2f4 R1CD
?D.0O
2a4 #on(%term de$t 2$4 )ther lia$ilities 2c4 6eferred income ta+es 2assumin( 100O considered as lia$ilities4 2d4 a S $ S c 2e4 Total e!uity 2f4 inority interests
9ro$a$ly the closest we can come to reconstruct Camp$ell&s computation of ??.O* item 17* is as follows 2PD0.D S P7D.4 H 2PD?@.? S P1*BG1.D4 Q ??O. This computation omits deferred ta+es and minority interests.
10-36
Chapter 10 - Credit Analysis
9ro$lem 10%G 2@ minutes4 a. 1. Ratio of Earnin(s to 5i+ed Char(es Te+t reference
/umerator
2a4 9re%ta+ income.................................................. 2$4 Interest e+pensed............................................. 2h4 Interest incurred............................................... 2d4 Interest part of operatin( rental e+pense...... 2f4 Amorti8ation of prior capitali8ed interest...... 2(4 ndistri$. inc. of Y0O owned affiliates........ P@*DD0 Ratio Q P@*DD0 H PB0 Q D.1
P@*B00 @00 %% 170 B0 2?004 PB0
6enominator
P
%% %% @@0 170 %% %%
7. Ratio of Cash 5rom )perations to 5i+ed Char(es /umerator
9re%ta+ income....................................................... Add (Deduct) adjustents 6epreciation........................................................... Amorti8ation of $ond premium............................ ,hare of minority interest in income................... ndistri$uted income of affiliates....................... Increase in accounts recei"a$le........................... 6ecrease in in"entory............................................ Increase in accounts paya$le............................... 9re%ta+ cash pro"ided $y operations.................. Int. e+p. 2P@004 S ond premium amor 2P?004..... Interest incurred..................................................... Interest portion of capital leases......................... PB*770 Ratio Q PB*770 H PB0 Q 11.11
6enominator
P@*B00
P %%
B00 2?004 700 2?004 2G004 D00 00 P*@00 00
%% %% %% %% %% %% %% %% %% @@0 170
170 PB0
?. Earnin(s Co"era(e of 9referred 6i"idends P@*DD0 H ZPB0 S P@00H21 % 0.@04 [ Q ?.GD $. The company&s co"era(e ratios su((est the e+istence of sufficient earnin(s and cash flows to co"er its fi+ed char(es. There is no e"idence of concern from any of these three co"era(e ratios. 5or a more complete analysis* we would want to collect "alues from other firms 2competitors4 and additional prior years for comparati"e analyses.
10-37
Chapter 10 - Credit Analysis
9ro$lem 10%10 a. 1. Ratio of Earnin(s to 5i+ed Char(es 9re%ta+ income....................................................... Int. incurred \ int. capitali8ed 2DD0S?@0%1704...... Amorti8ation of $ond discount............................ Interest portion of rental e+pense........................ Amorti8ation of prior capitali8ed interest........... ndistri$uted inc. of Y0O owned affiliates....... ,hare of minority interest.....................................
/umerator
6enominator
P*D00 1*100 100 @00 100 2@004 B00 P*00
P %% 1*770 100 @00 %% %% %% P1*70
Ratio Q P*00 H P1*70 Q @.@D 7. Ratio of Cash 5rom )perations to 5i+ed Char(es /umerator
9re%ta+ income....................................................... P *D00 Add $ac' e+penses not re!uirin( cash 6epreciation 2includes amorti8ation of pre"iously capitali8ed interest4............................ 1*700 Amorti8ation of $ond discount............................ 100 ,hare of minority interest..................................... B00 6eferred ta+es-already added $ac'.................. %% Increase in in"entories.......................................... 27*0004 6ecrease in accounts recei"a$le......................... 1*B00 Increase in accounts paya$le............................... 7*000 #ess ndistri$uted income of affiliates.............. 2@004 9re%ta+ cash pro"ided $y operations.................. D*G00 Interest e+pensed-$ond discount add $ac'..... 1*100 Interest portion of rental e+pense........................ @00 Interest incurred..................................................... P10*@00 Ratio Q P10*@00 H P1*70 Q B.0@
6enominator
P
%%
%% 100 %% %% %% %% %% %% %% %% @00 1*770 P1*70
?. Earnin(s Co"era(e of 9referred 6i"idends Ratio Q P*00 H ZP1*70 S P@00H21 % .@04 [ Q ?.7? $. The company&s co"era(e ratios su((est the e+istence of sufficient earnin(s and cash flows to co"er its fi+ed char(es. There is no e"idence of concern from any of these three co"era(e ratios. 5or a more complete analysis* we would want to collect "alues from other firms 2competitors4 and additional prior years for comparati"e analyses.
10-38
Chapter 10 - Credit Analysis
9ro$lem 10%11 2@0 minutes4 a. 1. Ratio of Earnin(s to 5i+ed Char(es 9re%ta+ income....................................................... Interest e+pense 2DD0 S ?@0 % 1704....................... Interest incurred 2DD0 S ?@04................................. Amorti8ation of $ond discount............................ Interest portion of rental payments..................... Amorti8ation of capitali8ed interest..................... ndistri$uted income of Y0O owned affiliates. ,hare of minority interest
/umerator
6enominator
PB*700 1*100 %% 100 @00 D0 2D004 B00 P*BD0
P
%% %% 1*770 100 @00 %% %% ]]]] P1*70
Ratio Q P*BD0 H P1*70 Q @.@ 7. Ratio of Cash 5rom )perations to 5i+ed Char(es 9re%ta+ income....................................................... Add 2deduct4 items to con"ert to cash $asis 6epreciation........................................................... Amorti8ation of $ond discount ........................... inority interest in income................................... ndistri$uted income of affiliates....................... Chan(es in Accounts recei"a$le............................................ In"entories............................................................ 9aya$le and accrued e+penses......................... 9re%ta+ cash from operations............................... Interest incurred 2DD0 S ?@04................................. Amorti8ation of $ond discount............................ Interest e+pense 2DD0 S ?@0 % 1704....................... Interest portion of rental e+pense........................
/umerator
6enominator
PB*700
P
1*700 100 B00 2D004 B00 21B04 170 *DB0 %% %% 1*100 @00 PG*?B0
%% %% %% %% %%
%% %% %% 1*770 100 @00 P1*70
Ratio Q PG*?B0 H P1*70 Q .@@ ?. Earnin(s co"era(e of preferred di"idends Ratio Q P*7D0 H ZP1*70 S P@00H21 % .@04 [ Q ?.0 $. ased on the calculations in part a* the super"isor&s concerns a$out the co"era(e ratios are misplaced. Indeed* the company&s co"era(e ratios su((est the e+istence of sufficient earnin(s and cash flows to co"er its fi+ed char(es. There is no e"idence of concern from any of these three co"era(e ratios. 5or a more complete analysis* we would want to collect "alues from other firms 2competitors4 and additional prior years for comparati"e analyses.
10-39
Chapter 10 - Credit Analysis
9ro$lem 10%17 20 minutes4 Interest incurred calculation 5irst ort(a(e onds .0O of *00 Q ? B.0O of 1*00 Q 1*00 1*@7 ,in'in( 5und 6e$entures B.O of 10*000 Q B0 Total interest incurred P7*0
a. Earnin(s Co"era(e Ratio on the 5irst ort(a(e onds 2pre%ta+ $asis4 214 ?.? $ased on :ear earnin(s* 2P@*0 H P1*@74 274 ?.1 $ased on %year a"era(e* Z2P@*0SP@*00SP@*00SP@*70SP@*0004H[H P1*@7 Earnin(s Co"era(e Ratio on the ,in'in( 5und 6e$entures 2pre%ta+ $asis4 214 .? $ased on :ear earnin(s* 2P@*0 H PB04 274 B.D $ased on %year a"era(e* Z2P@*0SP@*00SP@*00SP@*70SP@*0004H[H PB0 $. #on(%Term 6e$t to E!uity Ratio Ratio Q P?HP@ Q 0.@ @O of capital is de$t )f e!uity capital* @7.BO 2P70*000MHP@*0004 is senior to common stoc' M P1.10 preferred 2?00*000 + P704..................................... Class A shares.................................................................
P B*000 1@*000 P70*000
c. Earnin(s Co"era(e Ratio on the Cumulati"e Redeema$le 9referred Interest re!uirements for lon(%term de$t........................................... P7*0 P1.10 preferred di"idend-ta+ adjusted 2?00*00042P1.14H21%.04..... BB0 Re!uired pre%ta+.................................................................................... P7*? 214 1. Q $ased :ear earnin(s* 2P@*0 H P7*?4 274 1.B Q $ased on %year a"era(e* 2P@*@00 H P7*?4 d. Earnin(s per ,hare Computation Assumin( Con"ersion P@*0 :ear earnin(s $efore interest and ta+es 27*04 Interest e+pense P7*B 9re%ta+ income 21*??4 Ta+es 20O4 P1*??D After%ta+ income 2??04 P1.10 preferred di"idends 2?00*000 shares + P1.104 P1*00D A"aila$le for common shareholders 1.D mil P 0.B
Common shares 1 mil. S 0.D mil. 2Class A Con"ersion4 Earnin(s per share
10-40
Chapter 10 - Credit Analysis
9ro$lem 10%1? 2@ minutes4 a. Computation of Income and E9, under 6e$t "s. E!uity 5inancin( 6e$t Income $efore interest and ta+es-pre%e+pansion......... P70*000*000
E!uity P70*000*000
Additional income from e+pansion...................................
@*000*000
@*000*000
Income $efore interest and ta+es-post%e+pansion.......
7@*000*000
7@*000*000
Interest e+pense 2BO42P70*000*0004SP1*000*000.............
27*700*0004
21*000*0004
Income $efore ta+es..........................................................
71*D00*000
7?*000*000
Income ta+es 2@0O4...........................................................
2D*70*0004
2G*700*000 4
/et income
P1?*0D0*000
P1?*D00*000
Common shares outstandin(...........................................
7*000*000
7*@00*000
Earnin(s per share............................................................
PB.@
P.
$. Computation of E9, E!uality $etween 6e$t and E!uity 5inancin( 2EIT M % P7*700*000421 % .@04 7*000*000
2EIT M % P1*000*000421 % .@04 7*@00*000
M EIT Q Earnin(s efore Interest and Ta+es.
,ol"in( for EIT yields EIT Q PD*700*000 Interpretation When income $efore interest and ta+es is at PD*700*000* stoc'holders are indifferent $etween the de$t or e!uity financin( plans.
10-41
Chapter 10 - Credit Analysis
9ro$lem 10%1@ 2 minutes4 a. 1. !uaranteed "u#sidiary De#t . Add P70*000*000 to $oth lon(%term de$t and to fi+ed assets. Rationale nder the e!uity method of accountin( for joint "entures* the de$t incurred is not reported on the $alance sheet of the partners and therefore* this de$t should $e reflected in the adjusted de$t ratio since #u$$oc' has (uaranteed the total inde$tedness of the joint "enture. 7. $%&' eserve. Add P700*000*000 to $oth in"entory and to retained earnin(s 2i(norin( potential ta+ effects4. Rationale nder #I5) accountin(* #u$$oc' will report current costs for in"entory transactions in its income statement $ut its $alance sheet amount for endin( in"entory will reflect =first%in* still%here*> or 5I,. Accordin(ly* the ,EC re!uires companies usin( #I5) to disclose in notes to the financial statements the amounts $y which #I5) in"entories must $e increased to reflect current costs. #u$$oc' reports that under 5I5)* its in"entories would ha"e e+ceeded reported amounts $y P700*000*000. Accordin(ly* to reflect current costs* in"entories should $e stated on the adjusted $asis of 5I5)N also* retained earnin(s 2e+cludin( ta+ effects4 should $e credited $y the same amount that in"entories are de$ited $y. An alternati"e approach is to reco(ni8e a deferred ta+ lia$ility of P700*000 + current mar(inal ta+ rate. ?. 'perating $eases. These lon(%term operatin( leases could $e capitali8ed. The present "alue of these lon(%term leases must $e calculated usin( a discount rate. Assumin( 10O is the interest rate implicit in the lease* the present "alue is appro+imately P0*000*000. The present "alue amount should $e added to lon( term de$t and to fi+ed assets.
$. #on(%Term 6e$t to #on(%Term Capitali8ation efore Adjustments 2P millions4 #on(%term de$t #on(%term de$t S inority interest S ,hareholders& e!uity Q PB H 2PB S P100 S P@00 S P1*B04 Q 7?.GO #on(%Term 6e$t to #on(%Term Capitali8ation After Adjustments 2P millions4 #on(%term de$t S Kuaranteed de$t S #eases #on(%term de$t S inority interest S ,hareholders& e!uity S Kuaranteed de$t S In"entory Adjustment S #eases Q 2PBSP70SP04 H 2PBSP100SP@00SP1*B0SP70SP700SP04 Q @1.BO
10-42
Chapter 10 - Credit Analysis
9ro$lem 10%1@-concluded c. 1. Two points 2i4 5or fiscal years $e(innin( $efore 17H1BHG?* mar'eta$le securities were "alued at the lower of cost or mar'et under "&A" 2for mar'eta$le e!uity securities4 and A+ ,- 2for mar'eta$le de$t securities4. 6urin( this period the mar'et "alue of securities were sometimes su$stantially hi(her than shown on the $alance sheet* re!uirin( analytical adjustment. nder current practice* all mar'eta$le securities 2e+cept held%to%maturity de$t securities4 are "alued at mar'et. ence* only held%to%maturity de$t securities are potentially su$ject to mar'et adjustment. 2ii4 An analyst must reali8e that the lon(er the elapsed time since the $alance sheet date the (reater the li'elihood that mar'et "alues for mar'eta$le securities ha"e chan(ed. ence* for comparati"e analysis spannin( se"eral years* adjustments to mar'et may $e necessary for in"estment securities. 7. 6eferred income ta+es are created when a company uses different accountin( methods for income ta+ and financial reportin( such that so%called timin( differences in income occur. )ne school of thou(ht ar(ues that deferred ta+es should $e reco(ni8ed as a lia$ility. The presumption is that timin( differences will re"erse in the future and the ta+es will $ecome paya$le or that chan(es in the ta+ law could accelerate payment of such ta+es. )pponents ar(ue that deferred ta+es should $e included in shareholders& e!uity. The presumption here is that timin( differences are unli'ely to re"erse and therefore the $alance in deferred ta+es will continue to (row and not $ecome paya$le. This means that the lon(%term de$t ratio of a company would $e ad"ersely affected if deferred ta+es are considered lon(%term de$t 2first "iewpoint4N howe"er* this ratio would $e fa"ora$ly impacted if such ta+es are considered as part of shareholders& e!uity 2second "iewpoint4.
10-43
Chapter 10 - Credit Analysis
9ro$lem 10%1 2 minutes4 a. Ratio Computations 1. :ear P*700 a H P10*000$ Q 0. :ear B PD7*B00 a H P1?D*000$ Q 0.B0 a
Includes 214 Total current lia$ilities* 274 #on(%term de$t due after one year* and 2?4 6eferred income ta+es $ Includes 214 All items in 2a4 a$o"e* as well as 274 inority interest* and 2?4 ,toc'holders& e!uity
7. :ear P*700 H P@*000 Q 1.77 :ear B PD7*B00 H P@*000 Q 1.? ?. :ear P1*700 a H P@*D00$ Q .?B :ear B P7D*B00 a H P*@00$ Q .7 a
Includin( deferred ta+es. ,toc'holders& e!uity S minority interest.
$
@. :ear P1B*000 a
P@*000 P7*000 c P1B P1*000 e PA 000 ( P7 000 c P1B d
P1*000
?.@7
M #oss per income statement 2additional ?00 added $ac' in ,C5 represents di"idends recei"ed4.
:ear B P71*000 a
PC*@70$
P7*A00c
PG*7D0
(
P70 d
P7*A00 c
P1*700 e % P1*@00 f M M P70
d
7.B1
MM5rom the statement of cash flows 2income minus di"idends recei"ed4. a 9re%ta+ income $ Interest incurred % interest capitali8ed c Amorti8ation of $ond discount d Interest portion of operatin( rental e+pense e Amount of pre"iously capitali8ed interest amorti8ed in this period f Re"ersal of undistri$uted income 2loss4 of associated companies ( Interest incurred
10-44
Chapter 10 - Credit Analysis
9ro$lem 10%1-concluded . Cash from operationsM S income ta+ e+pense 2e+cept deferred ta+es4S fi+ed char(esMM
5i+ed char(esMM M
6epreciation added $ac' already includes amorti8ation of interest pre"iously capitali8ed. MMAs computed in 2@4 a$o"e.
:ear P*00 S 2P*D00%P1*0004 S P*01B H P*01B Q ?.0 :ear B PB*@00S2P10*000%P1*B004SP11*D00H P11*D00 Q 7.7 $. Analysis and Interpretation The financial le"era(e inde+* which underwent only minimal chan(e* is at a le"el su((esti"e of le"era(e $enefits to XETA&s stoc'holders. There also has $een a mar'ed increase in le"era(e as is indicated $y the total de$t to e!uity and the lon(%term de$t to e!uity measures. With total lia$ilities e+ceedin( e!uity $y o"er 0 percent* the le"el of lia$ilities is si(nificant. The relation of lon(%term de$t to e!uity is at a somewhat lower le"el. The earnin(s and cash flow co"era(e of fi+ed char(es are low on an a$solute $asis and ha"e declined from :ear to :ear B. This decline is primarily $ecause fi+ed char(es increased faster than net income. 5inally* operatin( cash flows declined in :ear B compared to :ear .
10-45
Chapter 10 - Credit Analysis
9ro$lem 10%1B 2B0 minutes4 a. Ratios ased on 9rojected :ear 6ata 1. )peratin( income H ,ales Q D.DO. 7. Earnin(s $efore interest and ta+es H Total assets Q 7.GO. ?. Times interest earned Q Earnin(s $efore interest and ta+esH Interest Q 1.01. @. #on(%term de$t H Total assets Q .O. $. Effect of :ear er(er on the Ratios and Creditworthiness of RT 1. )peratin( income to sales The creditworthiness of RT Corporation* from the standpoint of operatin( profit mar(in* declines $ecause of the mer(er. )peratin( mar(ins for the com$ined company is wea'er $ecause of the ina$ility to (enerate hi(her operatin( profits on the com$ined sales. ,till* this ratio should $e e"aluated o"er a lon(er term to determine whether the operatin( efficiency of the company is impro"in(. 7. EITHTotal assets The return on assets ratio declines. The company
10-46
Chapter 10 - Credit Analysis
9ro$lem 10%1B-concluded c. old or ,ell Analysis of RT onds $y Clayton Asset ana(ement Currently* the RT $onds are tradin( as %rated $onds. 9rior to the mer(er* RT
10-47
Chapter 10 - Credit Analysis
9ro$lem 10%1 20 minutes4 Recommendation uy the 9atriot anufacturin( $onds. 3uantitati"e ,upport for Recommendation The ratio information shows that 9atriot is less ris'y than ,turdy achines. 5irst* the pre%ta+ interest co"era(e of ,turdy achines is just o"er 1.0 "ersus 9atriot
10-48
Chapter 10 - Credit Analysis
CA,E, Case 10%1 2G0 minutes4 a. 5AL Corporation 5orecasted ,tatement of Cash Receipts and 9ayments 5or :ear Ended 6ecem$er ?1* :ear 7 e(innin( cash $alanceUUUUUUUU Add Cash Receipts e(innin( accounts recei"a$leU. S,ales for :ear 7 1 UUUUUU. % Endin( accounts recei"a$le 7... Cash collectionsUUUUUUUU. Total cash inflowsUUUUUUUUUU... 6educt Cash dis$ursements e(innin( accounts paya$leUU S9urchases for :ear 7 ? UUU... %Endin( accounts paya$le @ UU. 9ayments to creditorsUUUUU.. 9ayments of cash e+penses U. 9ayment of notes paya$le 9ayment of lon(%term de$tUUU.. Total cash dis$ursementsUUUUUUU. /et cash flowUUUUUUUUUUUUU #ess minimum cash $alanceUUUUUU Cash $orrowin(s e+pectedUUUUU /otes 10-49
P ?0*000
P
7*000
1*10@*000 27B*0004 DD0*000 G10*000
B0*000 B00*000 2*0004 D*000 ?1*G70
70*000 7*000 G@*G70 P2?*G704 270*0004 P2*G704
Chapter 10 - Credit Analysis
1 ,ales for :ear 7 Q ,ales for :ear 1 + 11O Q PGB0*000 + 1.1 Q P1*10@*000 7 Endin( A.R. Q A"era(e daily sales + Collection period Q P1*10@*000 + G0H?B0 Q P7B*000 ? 9urchases 2:ear 74 Q C)K, S Endin( in"entory % e(innin( in"entory C)K, 2:ear 74 Q C)K, 2:ear 14 + 110O Q P0*000 + 1.1 Q PB0*000 A"era(e In"entory Q C)K, H A"era(e in"entory turno"er Q PB0*000 H . Q 110*000 Endin( in"entory Q 2A"era(e in"entory + 74 % 2e(innin( In"entory4 Q P110*000 + 7 % P117*00 Q P10*00 9urchases 2:ear 74 Q PB0*000 S P10*00 % P117*00 Q PB00*000
10-50
Chapter 10 - Credit Analysis
Case 10%1-concluded /otes-continued @ Endin( A.9. Q 9urchases 2:ear 74 + 2e(. A.9. H :ear 1 9urchases4 Q PB00*000 + 2PB0*000 H P@D0*0004 Q P*000 Cash e+penses 2:ear 74 Q ,ellin( and Admin. e+penses S Ta+es paid ,A 2:ear 74 Q ,A 2:ear 14 + 110O Q P1B0*000 + 1.1 Q P1B*000 Income ta+ e+pense for :ear 7Q ,ales % 2C)K, S 6epreciation S ,A4 + .@D Q P1*10@*000 % 2PB0*000 S 2P?0*000 + 1.04 S P1B*000 + .@D Q P1?G*G70 Cash e+penses 2:ear 74 Q P1B*000 S P1?G*G70 Q P?1*G70
$. 5rom the analysis in part a* it is predicted that 5AL will need to $orrow P*G70 in :ear 7.
10-51
Chapter 10 - Credit Analysis
Case 10%7 2G0 minutes4 a. Jopp Corporation 5orecasted ,tatement of Cash Receipts and 9ayments 5or :ear Ended 6ecem$er ?1* :ear 7 e(innin( cash $alanceUUUUUUUU P ?0*000 Add Cash receipts e(. accounts recei"a$leUUUU. P 7*000 S,ales for :ear 7 1UUUUUU.. 1*10@*000 % Endin( accounts recei"a$le 7... 27B*0004 Cash collectionsU.UUUUUUU. DD0*000 Total cash inflowsUUUUUUUUUU... G10*000 6educt Cash dis$ursements e(. accounts paya$leUUUUU.. B0*000 S9urchases for :ear 7 ?UUUU. D7*BB % Endin( accounts paya$le @UU. 2*BDG4 9ayments to creditorsUUUUUU B@*GD 9ayments for cash e+penses U. ?1*G70 9ayment of notes paya$leUUUU 70*000 9ayment of lon(%term de$tUUU... 7*000 Total cash dis$ursementsUUUUUUU G7*DGD /et cash flowUUUUUUUUUUUU... P 21*DGD4 #ess inimum cash $alanceUUUUU.. Cash $orrowin(s e+pectedUUUUUU..
270*0004 P 2?*DGD4
/otes 1 :ear 7 ,ales Q :ear 1 ,ales + 11O Q PGB0*000 + 1.1 Q P1*10@*000 7 Endin( A.R. Q A"era(e daily sales + Collection 9eriod Q 2P1*10@*000H?B04 + G0 Q P7B*000 ? :ear 7 9urchases Q C)K, S Endin( in"entory % e(innin( in"entory :ear 7 C)K, Q :ear 1 C)K, + 110O Q P0*000 + 1.1 Q PB0*000 A"era(e in"entory Q C)K, H A"era(e in"entory turno"er Q PB0*000 H B Q P100*D??.?? Endin( in"entory Q 2A"era(e in"entory + 74 % 2e(innin( In"entory4 Q 2P100*D??.?? + 74 % P117*000 Q PDG*BB :ear 7 9urchases Q PB0*000 S PDG*BB % P117*000 Q PD7*BB @ Endin( A.9. Q :ear 7 9urchases + 2e(. A.9. H :ear 1 9urchases4 Q PD7*BB + 2PB0*000HP@0*0004 Q P*BDG :ear 7 cash e+penses :ear 1 sellin( and admin e+pense + 110O Q P1B0*000 + 1.10 Q P1B*000 :ear 7 income ta+ e+pense Q ,ales % 2C)K, S 6epr. S ,ellin( admin e+p.4 + .@D Q P1*10@*000 % 2PB0*000 S 2P?0*000 + 10O4 S P1B*0004 + .@D Q P1?G*G70 Cash e+penses Q P1B*000 S P1?G*G70 Q P?1*G70
$. 5rom the analysis in part a* it is predicted that 5AL will need to $orrow P?*DGD in :ear 7.
10-52
Chapter 10 - Credit Analysis
Case 10%? 2 minutes4 a. :ear :ear @
1.
Wor'in( capital Current assets Current lia$ilities Wor'in( capital
?@7*000 1*D00 1B@*700
1GD*000 B@*D00 1??*700
7.
Current ratio
1.G7
?.0B
?.
Acid%test ratio 2P17*000 S P1D?*0004 H P1*D00 2P1*000 S PD0*0004 H PB@*D00
1.10
Accounts recei"a$le turno"er P1*BD@*000 H 2P1D?*000 S PD0*0004 H 7 P1*70*000 H 2PD0*000 S PB0*0004 H 7
17.D1
Collection period of recei"a$les ?B0 H 17.D1 ?B0 H 1.DB
7D.10
In"entory turno"er ratio 2PG7*000 H 2P1@7*000 S PG*0004 H 7 2PD10*000 H 2PG*000 S P7*0004 H 7
.B
6ays to sell in"entory ?B0 H .B ?B0 H 10.DD
@B.?G
6e$t%to%e!uity ratio 2170 S ?0 S 1@.D4 H 2110 S [email protected] 2? S 1@.@ S 0.@4 H 2110 S B0.74
1.@B
Times interest earned PD*000 H P17*000 P@?*?00 H P*?00
.7
@.
.
B.
.
D.
G.
1.@
1.DB
70.1B
10.DD
??.0G
0.D1
.G?
$. Inde+%num$er trend series
:ear
:ear @ :ear ?
,alesUUUUUUUUUUUUU 1B0.@
11G.0
100.0
Cost of soldUUUUUU..
(oods 1D1.1
1D.7
100.0
Kross profitUUUUUUUUUU
1@0.
D1.D
100.0
ar'etin( and administrati"eU.
1@?.7
[email protected]
100.0
/et incomeUUUUUUUUUU...
117.
@.0
100.0
10-53
Chapter 10 - Credit Analysis
Case 10%?-concluded c. A loan should not $e (ranted* as it appears that the o"erall financial position of the company is deterioratin(. The followin( points should $e noted 1. The current ratio went down from ?.0B to 1.G7. 7. A similar reduction occurred in the acid%test ratio* indicatin( the company is in a wea'er position. ?. Accounts recei"a$le turno"er decreased while the collection period increased. This indicates a (reater in"estment in recei"a$les althou(h the collection period of 7D days is still within the firm&s terms of net ?0 days. @. The in"entory turno"er deteriorated from 10.DD to .B and the days to sell in"entory increased to @B days from ?? days. This means that the firm is carryin( a lar(er in"estment in in"entories* which ties up its $adly needed !uic' assets. In addition* the ris' of o$solete in"entory is increased. . 6e$t%to%e!uity ratio increased drastically. oth the short%term and lon(%term de$t were affected. The firm will pro$a$ly e+perience difficulty in meetin( its current maturities 2see current and acid%test ratio declines4 $ecause the firm is financin( its increased wor'in( capital needs with de$t instead of with e!uity. B. Althou(h sales increased dramatically* the firm incurred a (reater proportional increase in its costs. In :ear @* the firm had a lower (ross profit and a lower net income despite the increase in sales. In :ear * (ross profit increased* $ut at a slower rate than the increase in sales. This indicates that the firm is e+periencin( a costHprofit s!uee8e. efore any loans are made to the company* mana(ement must address the issues a$o"e and an impro"ed financial condition must $e demonstrated.
10-54
Chapter 10 - Credit Analysis
Case 10%@ 2D minutes4 a. The followin( ei(ht considerations are rele"ant for discussions with mana(ement and $e(innin( the tas' of credit analysis 1. Econoic cyclicality. ow closely do the to$acco* food* and $e"era(e industries trac' K/9 Is to$acco consumption more tied to sociopolitical and re(ulatory factors than to economic ones Cyclicality of an industry is the startin( point an analyst should consider in re"iewin( an industry. A company&s earnin(s (rowth should $e compared a(ainst the (rowth trend of its industry* with si(nificant de"iations carefully analy8ed. Industries may $e somewhat dependent on (eneral economic (rowth* demo(raphic chan(es* and interest rates. In (eneral* howe"er* industry earnin(s are not perfectly correlated with any one economic statistic. /ot only are industries sensiti"e to many economic "aria$les* $ut often se(ments within a company or industry mo"e with different la(s in relation to the o"erall economy. 7. !ro/th prospects. Are the $usinesses that Altria is operatin( within (rowin( at a steady pace* or is (rowth slippin( Will European consumption of ci(arettes $e(in to slow as they ha"e in the .,. due to more no smo'in( re(ulations Related to the issue of (rowth* is there consolidation (oin( on in to$acco* food or $e"era(es Alternate (rowth scenarios ha"e different implications for a company. With hi(h%(rowth industries* the need for additional capacity and related financin( is an issue. With low%(rowth industries* mo"ements toward di"ersification andHor consolidation strate(ies are a possi$ility. As a (eneral proposition* companies in hi(h%(rowth industries ha"e (reater potential for credit impro"ement than companies operatin( in lower%(rowth industries. ?. esearch 0 developent. R6 acti"ities are not lar(e in the to$acco* food or $e"era(e industries* althou(h e+penditures are directed at new product de"elopment. In (eneral* it is safe to characteri8e these $usinesses as ha"in( a sta$le product line that will not "ary much o"er time. 5or firms relyin( on such e+penditures to maintain or impro"e mar'et position* it is important to assess whether the company in !uestion has the financial resources to maintain a leadership position or at least e+pend a sufficient amount of money to 'eep technolo(ically current. @. Copetition. ow competiti"e are these industries Are there players who are out to (ain mar'et share at the e+pense of profits Is the industry trendin( toward oli(opoly* which would ma'e small companies in the industry "ulnera$le to the economies of scale the lar(er companies $rin( to $ear Economic theory shows us how competition within an industry relates to mar'et structure and has implications for pricin( fle+i$ility. An unre(ulated monopoly is in position to price its (oods at a le"el that will ma+imi8e profits. ost industries* howe"er* encounter free mar'et forces and cannot price their (oodsHser"ices without consideration of supply and demand as well as the price char(ed for su$stitute (oodsHser"ices. )li(opolies often ha"e a pricin( leader. Analysts must $e concerned a$out small companies in an industry that is trendin( toward oli(opoly. In such an en"ironment* the small company&s production costs may e+ceed those of the industry leaders. If a small firm is forced to follow the pricin( of the industry leaders* the firm may $e dri"en out of $usiness.
10-55
Chapter 10 - Credit Analysis
Case 10%@-concluded . "ources o1 supply. Are these $usinesses "ulnera$le to the cost of production inputs )r is the mar'et position of Altria such that it can easily pass on hi(her raw material costs Industry mar'et structure often has a direct impact on sources of supply. 5rom a competiti"e standpoint* the company that controls its factors of production is in a superior position. B. Degree o1 regulation. To$acco has faced some re(ulatory hurdles in the past 2especially the recent past4* as has food and $e"era(e to a lesser de(ree. What does the future hold in this area The analyst should $e concerned with the direction of re(ulation and its effect on future profita$ility. . $a#or. Are these $usinesses hea"ily unioni8ed What is the status of la$or%mana(ement relations When the la$or mar'et is Fti(ht*F this is an important consideration in nonunioni8ed companies. D. Accounting. 6o these $usinesses ha"e any uni!ue accountin( practices that warrant special attention As stressed throu(hout the te+t* an analyst must $ecome familiar with industry accountin( practices $efore proceedin( with a company analysis. To assess whether a company is li$eral or conser"ati"e in applyin( KAA9 industry practices should $e e+amined. $. 1a.Ratios for Altria for :ear G #e1ore the ac!uisition of Jraft are 9reta+ interest co"era(e Q 2P@*D70SP004HP00 Q 10.B@ #T de$t as O of capitali8ation Q P?*DD?H2P?*DD?SPG*G?14 Q 7D.11O C5 as O of total de$t Q 2P7*D70SP0SP100%P174H2P?*DD?SP1*1004 Q 1.1@O 1$.Ratios for Altria for :ear G pro 1ora for the ac!uisition of Jraft are 9reta+ interest co"era(e Q 2P@*@70SP1*B004HP1*B00 Q ?.B #T de$t as O of capitali8ation Q P1*DH2P1*DSPG*B4 Q B1.GGO C5 as O of total de$t Q 2P7*B@SP1*7?SP?G0%P174H2P1*DSP1*D?4 Q 7?.1@O 7. Relatin( these ratios to the median ratios for the "arious $ond ratin( cate(ories places Altria in the position shown $elow efore Jraft Ratio Implied Ratin( 9reta+ interest co"era(e.................................. 10.B@ AA #T de$t as O of cap.......................................... 7D.11O A C5 as O of total de$t........................................ 1.1@O ASHAA% After Jraft Ratio Implied Ratin( 9reta+ interest co"era(e.................................. ?.B #T de$t as O of cap.......................................... B1.GGO C5 as O of total de$t........................................ 7?.1@O Recommendation These ratios su((est that Altria $onds ha"e deteriorated from a stron( A ratin( to a ratin(* $ased on the median ratios for the "arious $ond cate(ories. Ki"en that Altria is in relati"ely sta$le $usinesses 2food and to$acco4 that tend to $e much less cyclical than the economy o"erall* an ar(ument could $e made that its $onds should $e rated as a stron( or e"en a .
10-56
Chapter 10 - Credit Analysis
Case 10% 2G0 minutes4 a. Asset 9rotection
:ear
:ear G
/et tan(i$le assets to #T de$t.............................
7.0O
@B.7O
oderate deterioration* $ut nothin( serious. The lar(e increase in the (oodwill account is e"idently a factor. #T de$t to total capitali8ation...............................
[email protected]
B7.BO
7.?1
1.D?
odest impro"ement. 6e$t to common e!uity.........................................
Kood impro"ement due to more rapid (rowth in retained earnin(s. Total assets to total shareholders& e!uity...........
?.??
?.@0
,li(ht impro"ement. #i!uidity
:ear
:ear G
Collection period................................................... In"entory turno"er..................................................
BD 17.0
G0 @.
Its petrochemicals ac!uisitions ha"e increased AEL&s wor'in( capital re!uirements* particularly accounts recei"a$le and in"entories. ,hort%term de$t to lon(%term de$t.......................
.DO
G.?O
The (reater wor'in( capital re!uirements ha"e e"idently forced AEL to rely more hea"ily on short%term de$t. Earnin( 9ower
:ear
:ear G
9reta+ interest co"era(e....................................... )peratin( cash flow to lon(%term de$t...............
1.D0 70.@O
1.D@ 77.1O
9reta+ interest co"era(e is similar $etween :ear and :ear G* althou(h it was si(nificantly hi(her in :ear D 27.@4. i(her operatin( mar(ins and impro"ed cash flow helped in supportin( the hi(her de$t $urden. This is especially e"ident in the operatin( cash flow to lon(%term de$t ratio.
10-57