CREDIT ANALYSIS

• Section 1: Liquidity
• Liquidity and Working Capital
• Operating Activity Analysis of Liquidity
• Additional Liquidity Measures
• Section 2: Capital Structure and Solvency
• Basics of Solvency
• Capital Structure Composition and Solvency
• Earnings Coverage
 LEARNING OBJECTIVES
• Explain the importance of liquidity and describe working capital measures
of liquidity and their components.
• Interpret the current ratio and cash-based measures of liquidity.
• Analyze operating cycle and turnover measures of liquidity and their
interpretation.
• Describe capital structure and its relation to solvency.
• Explain financial leverage and its implications for company performance
and analysis.
• Analyze adjustments to accounting book values to assess capital
structure.
 LEARNING OBJECTIVES
• Describe analysis tools for evaluating and interpreting capital
structure composition and for assessing solvency.
• Analyze asset composition and coverage for solvency analysis.
• Explain earnings-coverage analysis and its relevance in evaluating
solvency.
• Describe capital structure risk and return and its relevance to financial
statement analysis.
• Interpret ratings of organizations’ debt
SECTION 1:
LIQUIDITY
 Liquidity

Liquidity and Operating Activity Additional Liquidity

Working Capital Measures
Receivables liquidity
Current assets Inventory turnover Asset composition
Current liabilities Liquidity of current liabilities Liquidity index
Working capital Acid-test ratio
Current ratio Cash flow measures
Cash-based ratios Financial flexibility
MD&A
 • Liquidity refers to the availability of company
resources to meet short-term cash
requirements.

LIQUIDITY • Short term is conventionally viewed as a

AND period up to one year, though it is identified
with the normal operating cycle of a company
WORKING
CAPITAL • Analysis of liquidity is aimed at companies’
operating activities, their ability to generate
profits from sale of products and services and
working capital requirements and measures.
 LIQUIDITY AND WORKING CAPITAL

Effects of lack of liquidity:

prevents a company from taking advantage of favorable discounts or
profitable opportunities.

This can lead to forced sale of investments and other assets at reduced
prices and, in its most severe form, to insolvency and bankruptcy.

For a company’s shareholders, it can foretell a loss of owner control or loss

of capital investment.
 LIQUIDITY AND WORKING CAPITAL

Effects of lack of liquidity:

To creditors of a company, it can yield delays in collecting interest and

principal payments or the loss of amounts due them.

a company’s inability to execute contracts and damage to important

customer and supplier relationships.
 Working Capital
• Defined as the excess of current assets
LIQUIDITY over current liabilities.
AND
WORKING • It is important as a measure of liquid
CAPITAL assets that provide a safety cushion to
creditors.
 Current Assets and Liabilities

Current assets are cash and Current liabilities are

other assets reasonably
expected to be (1) realized in obligations expected to
cash or (2) sold or consumed be satisfied within a
within one year (or the normal relatively short period
operating cycle of the of time, usually one
company if greater than one
year). year.
Current CURRENT ASSETS CURRENT LIABILITIES
Assets and
• Cash • Accounts payable
Liabilities • Marketable securities • Notes payable
maturing within the • Short-term bank
next fiscal year loans
• Accounts receivable • Taxes payable
• Inventories • Accrued expenses
• Prepaid expenses • Current portion of
long-term debt
 Working Capital Measure of Liquidity

• Working capital = Current assets – Current liabilities

• It is also important in measuring the liquid reserve available to meet

contingencies and the uncertainties surrounding a company’s
balance of cash inflows and outflows.
 Working Capital
Measure of Liquidity

Company A Company B
ILLUSTRATION: Current assets 300,000 1,200,000
The following two companies Current liabilities - 100,000 - 1,000,000
have an equal amount of
working capital. Which of the Working capital 200,000 200,000
two company is more superior
in terms of working capital?
 Current Ratio Measure of Liquidity

• Indicates the extent to which current liabilities are covered by those assets
expected to be converted to cash in the near future.

Current assets
Current ratio =
Current liabilities
Relevance of the Current Ratio

CURRENT LIABILITY BUFFER AGAINST RESERVE OF LIQUID

COVERAGE LOSSES FUNDS
 Year 1 Year 2
Current assets 300,000 600,000
Comparative Current liabilities 100,000 400,000
Analysis
Working capital 200,000 200,000
Current ratio 3 1.5

ILLUSTRATION:
Technology Resources, Inc., experiences a doubling of current assets and a
quadrupling of current liabilities with no change in its working capital.
 2x or more – a company is
Rule of financially sound
Thumb
Analysis:
Current Ratio Below 2x – suggests
increasing liquidity risks
 Cash-Based Ratio Measures of Liquidity
Cash to Current Assets Ratio
• A ratio of “near-cash” assets to the total of current assets.
• The larger this ratio, the more liquid are current assets.

Cash + Cash equivalents + Marketable securities

Current assets
 Cash-Based Ratio Measures of Liquidity
Cash to Current Liabilities Ratio
• Measures the cash available to pay current obligations

Cash + Cash equivalents + Marketable securities

Current liabilities
 Three operating activity measures
OPERATING based on:
ACTIVITY
ANALYSIS OF  Accounts receivable
LIQUIDITY  Inventory
 Current Liabilities
 Quality refers to • A measure of this likelihood is
the likelihood of the proportion of receivables
collection within terms of payment set
without loss. by the company.
Accounts
Receivable
Liquidity
Liquidity refers to
Measures the speed in
converting • The receivables turnover rate
accounts is a measure of this speed.
receivable to
cash.
 Accounts Receivable Turnover

• Indicates how often, on average, receivables revolve –

that is, are received and collected during the year.

Accounts Receivable Net sales on credit

=
Turnover Ratio Average accounts receivable
Accounts Receivable Turnover
Illustration

• Consumer Electronics reports sales of $1,200,000, beginning

receivables of $150,000, and yearend receivables of
$250,000. What is its accounts receivable turnover ratio?
 Days Sales Outstanding

• measures the number of days it takes, on average, to

collect accounts receivable based on the average
balance in accounts receivable.

Days' sales 365

=
outstanding Accounts receivable turnover
Interpretation of Receivables Liquidity Measures
• Accounts receivable turnover rates and collection periods are usefully
compared with industry averages or with the credit terms given by
the company.

• When the collection period is compared with the terms of sale

allowed by the company, we can assess the extent of customers
paying on time
 Inventories are investments made for purposes
of obtaining a return through sales to
customers.

Inventory In most companies, a certain level of inventory

Turnover must be kept.
Measures
• If inventory is inadequate, sales volume declines
below an attainable level.
• Conversely, excessive inventories expose a company
to storage costs, insurance, taxes, obsolescence, and
physical deterioration.
 Inventory Turnover

• measures the average rate of speed at which

inventories move through and out of a company.

Inventory turnover Cost of goods sold (COGS)

=
ratio Average inventory
 Days to sell inventory ratio

• This ratio tells us the number of days a company takes

in selling average inventory for that year.

Days' to sell 365

=
inventory ratio Inventory turnover ratio
Illustration
Selected financial information from Macon Resources for Year
8 is reproduced below:
Sales . . . . . . . . . . . . . . . $1,800,000
Cost of goods sold . . . . . 1,200,000
Beginning inventory. . . . 200,000
Ending inventory . . . . . . 400,000
Compute for Inventory turnover ratio and days to sell
inventory.
Interpretation of Inventory Turnover
• Inventory turnover ratios offer measures of both the quality and
liquidity of the inventory component of current assets.

• Quality of inventory refers to a company’s ability to use and dispose

of inventory.

• When inventory turnover decreases over time, or is less than the

industry norm, it suggests slow-moving inventory items attributed to
obsolescence, weak demand, or nonsalability
 Conversion period or Operating cycle

• This measure combines the collection period of

receivables with the days to sell inventories to obtain
the time interval to convert inventories to cash.

Conversion period = Days sales outstanding +

Days to sell inventory ratio
 Current liabilities are important in
computing both working capital and the
current ratio for two related reasons:

Liquidity of 1. Current liabilities are used in

Current determining whether the excess of current
assets over current liabilities affords a
Liabilities sufficient margin of safety.
2. Current liabilities are deducted from
current assets in arriving at working
capital.
 Accounts payable turnover

• This ratio indicates the speed at which a company pays

for purchases on account.

Accounts payable Cost of goods sold (COGS)

=
turnover Average accounts payable
 Days to pay accounts payable

• The days to pay accounts payable provides an indication of the

average time the company takes in paying its obligations to
suppliers.
• The longer the payment period, the greater the use of suppliers’
capital.

Days to pay 365

=
accounts payable Accounts payable turnover
 Cash Conversion Cycle

• A metric that expresses the length of time (in days) that

it takes for a company to convert its investments in
inventory and other resources into cash flows from sales.
• This metric takes into account the time needed to sell its
inventory, the time required to collect receivables, and
the time the company is allowed to pay its bills without
incurring any penalties.
 Cash Conversion Cycle (CCC)

CCC = Days sales outstanding + Days to sell inventory -

Days to pay accounts payable

• A trend of decreasing or steady CCC values over

multiple periods is a good sign, while rising ones should
lead to more investigation and analysis based on other
factors.
 Current Assets Composition
Acid-Test (Quick) Ratio
ADDITIONAL Cash Flow Measures
LIQUIDITY Financial Flexibility
MEASURES Management’s Discussion and
Analysis
 The composition of current assets
is an indicator of working capital
Current and liquidity.
Assets
Compositio Use of common-size percentage
n comparisons facilitates our
evaluation of comparative liquidity,
regardless of the dollar amounts.
 Texas Electric’s current assets along with their
common-size percentages are reproduced
below for Years 1 and 2:

Illustration Current Assets Year 1 Year 2

Cash 30,000 30% 20,000 20%
Accounts receivable 40,000 40% 30,000 30%
Inventories 30,000 30% 50,000 50%
Total current assets 100,000 100% 100,000 100%
 Acid-Test (Quick) Ratio

• This ratio includes those assets most quickly convertible to

cash and is computed as:

Cash + Cash equivalents + Marketable securities + Accounts receivable

Current liabilities
 Inventories are often the least liquid of
current assets and are not included in
the acid-test ratio.
Acid-Test
(Quick)
Ratio Another reason for excluding
inventories is that their valuation
typically involves more managerial
discretion than required for other
current assets.
 Cash Flow Ratio

• a measure of how well current liabilities are covered by the

cash flows generated from a company's operations

Operating cash flow

Cash flow ratio =
Current liabilities
 Financial flexibility is the ability of a
company to take steps to counter
unexpected interruptions in the flow of
funds.
Financial
Flexibility It can mean the ability to borrow from
various sources, to raise equity capital,
to sell and redeploy assets, or to adjust
the level and direction of operations to
meet changing circumstances
 Additional factors bearing on
an assessment of a company’s
financial flexibility are:
Financial • ratings of its commercial paper,
bonds, and preferred stock,
Flexibility • any restrictions on its sale of assets,
• the extent expenses are
discretionary, and
• ability to respond quickly to
changing conditions
 The Securities and Exchange Commission
requires companies to include in their
annual reports an expanded management
discussion and analysis of financial
Management’s condition and results of operations (MD&A).
Discussion
and Analysis The financial condition section requires a
discussion of liquidity—including known
trends, demands, commitments, or
uncertainties likely to impact the company’s
ability to generate adequate cash.
END