McGraw-Hill/Irwin
10-2
Credit Analysis
10
CHAPTER
10-3
10-4
10-5
Denominator Considerations
Payables vary with sales. Current liabilities do not include prospective cash outlays.
10-6
10-7
Note of caution
Quality of current assets and the composition of current liabilities are more important in evaluating the current ratio. Working capital requirements vary with industry conditions and the length of a companys net trade cycle.
10-8
10-9
Larger the ratio, the more cash available to pay current obligations
10-10
10-11
Accounts receivable turnover rates and collection periods are usefully compared with industry averages or with credit terms. Ratio Calculation: Gross or Net? Trend Analysis
Collection period over time. Observing the relation between the provision for doubtful accounts and gross accounts receivable.
10-12
10-13
10-14
10-15
10-16
10-17
10-18
Overcomes the static nature of the current ratio since its numerator reflects a flow variable.
10-19
10-20
Technique to trace through the effects of changes in conditions/ policies on cash resources of a company
10-21
Anticipates 10 percent growth in sales for Year 2 All revenue and expense items are expected to increase by 10 percent, except for depreciation, which remains the same All expenses are paid in cash as they are incurred Year 2 ending inventory is projected at $150,000 By the end of Year 2, predicts notes payable of $50,000 and a zero balance in accrued taxes Maintains a minimum cash balance of $50,000
10-22
768,750 $ 838,750
(continued)
10-23
(b)Year 2 cost of sales*: $520,000 1.1 = $ Ending inventory (given) Goods available for sale $ Beginning inventory Purchases $ * Excluding depreciation. (c)
(d) Gross profit ($825,000 $572,000) $253,000 Less: Net income $ 24,500* Depreciation 25,000 ( 49,500) Other cash expenses $203,500 *110 percent of $20,000 (Year 1 N.I.) + 10 percent of $ 25,000 (Year 1 depreciation).
10-24
Basics of Solvency
Solvency long-run financial viability and its ability to cover long-term obligations Capital structure financing sources and their attributes Earning power recurring ability to generate cash from operations Loan covenants protection against insolvency and financial distress; they define default (and the legal remedies available when it occurs) to allow the opportunity to collect on a loan before severe distress
10-25
Basics of Solvency
Capital Structure
Equity financing
Risk capital of a company Uncertain and unspecified return Lack of any repayment pattern Contributes to a companys stability and solvency
Debt financing
Must be repaid with interest Specified repayment pattern
When the proportion of debt financing is higher, the higher are the resulting fixed charges and repayment commitments
10-26
Basics of Solvency
Motivation for Debt
10-27
Basics of Solvency
Financial Leverage- Illustrating Tax Deductibility of Interest
10-28
Basics of Solvency
Adjustments for Capital Structure - Liabilities
Potential accounts needing adjustments
Deferred Income Taxes - Is it a liability, equity, or some of both? Operating Leases - capitalize noncancelable operating leases? Off-Balance-Sheet Financing Contingent Liabilities Minority Interests Convertible Debt Preferred Stock
Chapter reference
3&6 3 3 3&6 5 3 3
10-29
10-30
10-31
Capital structure measures serve as screening devices. Further analysis required if debt is a significant part of capitalization.
10-32
10-33
Earnings Coverage
Earnings to Fixed Charges Limitation of capital structure measures - inability to focus on availability of cash flows to service debt. Role of earnings coverage, or earning power, as the source of interest and principal repayments. Earnings to fixed charges ratio
10-34
Earnings Coverage
Earnings to Fixed Charges
10-35
10-36
Earnings Coverage
Times Interest Earned
Numerator sometimes referred to as earnings before interest and taxes, or EBIT. Potentially misleading and not as effective an analysis tool as the earnings to fixed charges ratio.
10-37
Earnings Coverage
Relation of Cash Flow to Fixed Charges
10-38
Earnings Coverage
Earnings Coverage of Preferred Dividends
10-39
Earnings Coverage
Interpreting Earnings Coverage Earnings coverage measures provide insight into the ability of a company to meet its fixed charges High correlation between earnings-coverage measures and default rate on debt Earnings variability and persistence is important Use earnings before discontinued operations, extraordinary items, and cumulative effects of accounting changes for single year analysis but, include them in computing the average coverage ratio over several years
10-40
Earnings Coverage
Capital Structure Risk and Return A company can increase risks (and potential returns) of equity holders by increasing leverage Substitution of debt for equity yields a riskier capital structure Relation between risk and return in a capital structure exists Only personal analysis can reflect ones unique risk and return expectations
Return $ Risk ?