1、11CHAPTERCredit AnalysisMcGraw-Hill/Irwin 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.1Company Liquidity refers to the ability to meet short-term obligationsLiquidity is the ability to convert assets into cash or to obtain cashShort term is the longer of one-year or the company operati

2、ng cycleLiquidity and Working Capital Basics2Liquidity is a matter of degreeLack of liquidity can limitAdvantages of favorable discountsProfitable opportunitiesManagement actionsCoverage of current obligationsLiquidity and Working Capital Basics3Severe illiquidity often precedesLower profitabilityRe

3、stricted opportunitiesLoss of owner controlLoss of capital investmentInsolvency and bankruptcyLiquidity and Working Capital Basics4Current assets are cash and other assets reasonably expected to be (1) realized in cash, or (2) sold or consumed, during the longer of one-year or the companys operating

4、 cycleCurrent assets include:Cash - ultimate liquid assetCash equivalents - temporary investments of excess cashMarketable securities - debt or equity securities held as s-t investmentsAccounts receivable - mounts due from credit salesInventories - items held for sale in the normal course of busines

5、sPrepaid expenses - advance payments for services and suppliesLiquidity and Working Capital Current Assets5Classification as current asset depends on:1. Manaments intent2. Industry practiceAnalysis must assess this classification1. Is classification as current asset appropriate?2. If not, then adjus

6、t accounts and amounts among current and noncurrentLiquidity and Working Capital Current AssetsBalance Sheet6Classification as current liability depends on:1. Manaments intent2. Industry practiceAnalysis must assess this classification1. Is classification as current liability appropriate?2. If not,

7、then adjust accounts and amounts among current and noncurrent3. Are current liabilities reported?4. If not, then adjust accounts for these amountspotential examples: Contingent liabilities associated with loan guarantees Future minimum rental payments under noncancelable operating leases Progress pa

8、yments under contracts Current deferred tax liabilities (and assets)Liquidity and Working Capital Current Liabilities7Working capital isdefined as the excess of current assets over current liabilitiesWidely used measure of short-term liquidityDeficient when current liabilities exceed current assetsI

9、n surplus when current assets exceed current liabilitiesA margin of safety for creditorsA liquid reserve to meet contingencies and uncertaintiesA constraint for technical default in many debt agreementsLiquidity and Working Capital Working Capital8Working capital more relevant when related to other

10、key variables such asSalesTotal assetsWorking capital is of limited value as an absolute amountLiquidity and Working Capital Working Capital9Current Ratio Reflects on: Current liability coverage - assurance in covering current liabilities Buffer against losses - margin of safety for shrinkage in non

11、cash current assets Reserve of liquid funds -margin of safety against uncertainties and shocks to cash flowsLiquidity and Working Capital Current Ratio10Current Ratio Limitations:If liquidity is the ability to meet cash outflows with adequate cash inflows, then does the current ratio:Measure and pre

12、dict the pattern of future cash inflows and outflows?Measure the adequacy of future cash inflows to outflows?Answer is generally no to both these questionsCurrent ratioIs a static measureDoes not have a causal relation to future cash inflowsLiquidity and Working Capital Current Ratio11Current Ratio

13、Limitations in NumeratorAdjustments often needed to counter various limitations such asFailure to reflect open lines of creditAdjust securities valuation since the balance sheet dateReflect revolving nature of accounts receivableRecognize profit margin in inventoryAdjust inventory values to marketRe

14、move deferred charges of dubious liquidity from prepaid expensesLiquidity and Working Capital Current Ratio12Three important qualifications1. Liquidity depends to a large extent on prospective cash flows2.No direct relation between working capital account balances and patterns of future cash flows3.

15、 Managerial policies are directed primarily at efficient and profitable asset utilization and secondly at liquidity4.Cash flow forecasts and pro forma financial statements are preferred over the current ratio for liquidity and solvency analysis 5. Current ratio is a static measure of the ability of

16、current assets to satisfy current liabilitiesLiquidity and Working Capital Current Ratio13Two important elements are integral to use of the current ratio1.Quality of both current assets and current liabilities2.Turnover rate of both current assets and current liabilitiesLiquidity and Working Capital

17、 Current Ratio14Comparative AnalysisTwo useful tools in analyzing the trend in the current ratioTrend analysis - components of working capital and the current ratio are converted to indexes and examined over timeCommon-size analysis - composition of current assets is examined over timeLiquidity and

18、Working Capital Current Ratio - Applications15Ratio Management (window dressing)Examples are:Press the collection of receivables at year-endCall in advances to officers for temporary repaymentReduce inventory below normal levelsDelay normal purchasesProceeds from these activities are then used to pa

19、y off current liabilitiesLiquidity and Working Capital Current Ratio - Applications16Rule of Thumb Analysis (2:1) 2:1 superior coverage of current liabilities (but not too high, suggesting inefficient use of resources and reduced returns) 2:1 deficient coverage of current liabilitiesLiquidity and Wo

20、rking Capital Current Ratio - Applications17Net Trade Cycle AnalysisWorking capital requirements are affected by its desired inventory investment and the relation between credit terms from suppliers and those extended to customersLiquidity and Working Capital Current Ratio - Applications18Net Trade

21、CycleIllustrationSelected financial information from Technology Resources, Inc., for the end of Year 1 is reproduced below:Sales for Year 1 $360,000Receivables40,000Inventories*50,000Accounts payable20,000Cost of goods sold(including depreciation of $30,000)320,000*Beginning inventory is $100,000.We

22、 assume these relate to purchases included in cost of goods sold.We estimate Technology Resources purchases per day as:Purchases per day = $240,000 360 = $666.67The net trade cycle for Technology Resources is computed as (in days):Liquidity and Working Capital Current Ratio - Applications19Sales Tre

23、nd AnalysisTrend analysis review of sales trend across timeLiquidity and Working Capital Current Ratio - Applications20Cash to Current Assets RatioLarger the ratio, the more liquid are current assetsLiquidity and Working Capital Cash-Based Ratio of Liquidity21Cash to Current Liabilities RatioLarger

24、the ratio, the more cash available to pay current obligationsLiquidity and Working Capital Cash-Based Ratio of Liquidity22Accounts Receivable TurnoverOperating Activity Analysis of LiquidityAccounts Receivable Liquidity23Operating Activity Analysis of LiquidityAccounts Receivable LiquiditySource: Du

25、n & Bradstreet24 Accounts Receivable Collection PeriodOperating Activity Analysis of LiquidityAccounts Receivable Liquidity25Days Sales in Receivables (Alternative to Collection Period)Operating Activity Analysis of LiquidityAccounts Receivable Liquidity26Temporal Trend AnalysisTrend in:1. Collectio

26、n period over time2. Operating Activity Analysis of LiquidityAccounts Receivable Liquidity27Inventory TurnoverMeasures the average rate of speed inventories move through and out of a companyOperating Activity Analysis of LiquidityInventory Turnover28Days to Sell Inventory Useful in assessing purchas

27、ing and production policiesshows the number of days a company takes in selling average inventory for that yearAlternative computation- Days Sales in Inventorywhere the cost of average days sales is:Shows the number of days required to sell ending inventoryOperating Activity Analysis of LiquidityInve

28、ntory Turnover29Selected financial information from Macon Resources, Inc., for the end of Year 8 is reproduced below:Sales$1,800,000Cost of goods sold 1,200,000Beginning inventory 200,000Ending inventory 400,000Inventory turnover ratios using average inventory are computed as:Inventory turnover rati

29、os based on ending inventory equal:Operating Activity Analysis of LiquidityInventory Turnover - Illustration30Conversion Period (Operating Cycle): Days to Sell Inventory + Collection PeriodMeasure of the speed with which inventory is converted to cashOperating Activity Analysis of LiquidityInventory

30、 Turnover31Quality of Current Liabilities Must be judged on their degree of urgency in paymentMust be aware of unrecorded liabilities having a claim on current fundsOperating Activity Analysis of LiquidityLiquidity of Current Liabilities32Days Purchases in Accounts Payable Measures the extent accoun

31、ts payable represent current and not overdue obligationsOperating Activity Analysis of LiquidityInventory Turnover33Additional Liquidity Measures Asset CompositionComposition of current assets is an indicator of working capital liquidityUse ofcommonsize percentage comparisons facilitates this analys

32、isBalance Sheet34Acid-Test (Quick) RatioIs a more stringent test of liquidityvis-vis current ratioAdditional Liquidity Measures 35Acid-Test (Quick) RatioAdditional Liquidity Measures Source: Dun & Bradstreet(Cash + Account Receivables/Current Liabilities)36Cash Flow MeasuresCash Flow RatioA ratio of

33、 0.40 or higher is common for healthy companiesAdditional Liquidity Measures 37Financial FlexibilityFinancial flexibility - ability of a company to take steps to counter unexpected interruptions in the flow of fundsFocus of analysis:Ability to borrow from various sourcesTo raise equity capitalTo sel

34、l and redeploy assetsTo adjust the level and direction of operations to meet changing circumstancesLevels of prearranged financing and open lines of creditAdditional Liquidity Measures 38Managements Discussion and AnalysisMD&A requires a discussion of liquidity includingKnown trendsDemandsCommitment

35、sUncertaintiesAbility to generate cashInternal and external sources of liquidityAny material unused sources of liquid assetsAdditional Liquidity Measures 39Additional Liquidity Measures What-If AnalysisWhat-if analysis - technique to trace through the effects of changes in conditions or policies on

36、the cash resources of a company40What-If Analysis - IllustrationBackground DataConsolidated Technologies at December 31, Year 1:Cash$70,000Accounts receivable 150,000Inventory 65,000Accounts payable 130,000Notes payable 35,000Accrued taxes 18,000Fixed assets 200,000Accumulated depreciation 43,000Cap

37、ital stock 200,000The following additional information is reported for Year 1:Sales $750,000Cost of sales 520,000Purchases 350,000Depreciation 25,000Net income 20,000Anticipates 10 percent growth in sales for Year 2All revenue and expense items are expected to increase by 10 percent, except for depr

38、eciation, which remains the sameAll expenses are paid in cash as they are incurredYear 2 ending inventory is projected at $150,000By the end of Year 2, predicts notes payable of $50,000 and a zero balance in accrued taxesMaintains a minimum cash balance of $50,000Additional Liquidity Measures 41What

39、-If Analysis - IllustrationCase 1: Consolidated Technologies is considering a change in credit policy where ending accounts receivable reflect 90 days of sales. What impact does this change have on the companys cash balance? Will this change affect the companys need to borrow? Our analysis of this w

40、hat-if situation is as follows:Cash, January 1, Year 2$70,000Cash collections:Accounts receivable, January 1, Year 2$150,000Sales 825,000Total potential cash collections$975,000Less: Accounts receivable, December 31, Year 2 ( 206,250)(a) 768,750Total cash available$838,750Cash disbursements:Accounts

41、 payable, January 1, Year 2$130,000Purchases 657,000(b)Total potential cash disbursements$787,000Accounts payable, December 31, Year 2 ( 244,000)(c)$543,000Notes payable, January 1, Year 2$ 35,000Notes payable, December 31, Year 2 ( 50,000) (15,000)Accrued taxes 18,000Cash expenses(d) 203,500 749,50

42、0Cash, December 31, Year 2$89,250Cash balance desired 50,000Cash excess$ 39,250Explanations:(a)(b)Year 2 cost of sales*: $520,000 1.1 =$572,000 Ending inventory (given) 150,000 Goods available for sale$722,000 Beginning inventory ( 65,000) Purchases$657,000 * Excluding depreciation.(c) (d) Gross pro

43、fit ($825,000 $572,000)$253,000 Less:Net income$24,500* Depreciation 25,000 ( 49,500) Other cash expenses$203,500 *110 percent of $20,000 (Year 1 N.I.) + 10 percent of $ 25,000 (Year 1 depreciation).Additional Liquidity Measures 42Solvency - long-run financial viability and its ability to cover long

44、-term obligationsCapital structure - financing sources and their attributesEarning power recurring ability to generate cash from operationsLoan covenants protection against insolvency and financial distress; they define default (and the legal remedies available when it occurs) to allow the opportuni

45、ty to collect on a loan before severe distressBasic of Solvency Facts43Equity financingRisk capital of a companyUncertain and unspecified returnLack of any repayment patternContributes to a companys stability and solvencyDebt financingMust be repaid with interestSpecified repayment patternWhen the p

46、roportion of debt financing is higher, the higher are the resulting fixed charges and repayment commitmentsBasic of Solvency Capital Structure44From a shareholders perspective, debt financing is less expensive than equity financing because:1.Financial Leverage-Interest on most debt is fixed, and pro

47、vided interest is less than the return earned from debt financing, the excess return goes to equity investors2.Tax Deductibility of Interest-Interest is a tax-deductible expense whereas dividends are notBasic of Solvency Motivation for Debt45Leverage - use of debt to increase net incomeLeverage:Magn

48、ifies both managerial success (profits) and failure (losses)Increases risksLimits flexibility in pursuing opportunitiesDecreases creditors protection against lossCompanies with leverage are said to be trading on the equity omplying a company is using equity financing to obtain debt financing in a de

49、sire to reap returns above the cost of debt.Basic of Solvency Financial Leverage46Trading on the EquityReturns for Different Earnings Levels ($ thousands)Financing Sources Return on Income before Interest and10 PercentNet Net Income + InterestAssetsDebtEquityTaxesDebt InterestTaxes*Income (1 - Tax R

50、ate) AssetsEquityYear 1:Risky, Inc.$1,000,000$400,000$600,000$200,000$40,000$64,000$96,000$120,000 12.0%16.0%Safety, Inc.1,000,0001,000,000200,00080,000120,000120,00012.012.0Year 2:Risky, Inc.1,000,000400,000600,000100,00040,00024,00036,00060,000 6.06.0Safety, Inc.1,000,0001,000,000100,00040,00060,0

51、0060,0006.06.0Year 3:Risky, Inc.1,000,000400,000600,00050,00040,0004,0006,00030,000 3.01.0Safety, Inc.1,000,0001,000,00050,00020,00030,00030,0003.03.0* Tax rate is 40 percent. Return on assets = Net income + Interest (1 0.40)/Assets. Return on equity = Net income/Shareholders equity.Basic of Solvenc

52、y Financial Leverage - Illustration47Consider two companies results for Year 2:Year 2 FinancialsRisky, Inc.Safety, Inc.Income before interest and taxes$100,000$100,000Interest (10% of $400,000)40,000Income before taxes$60,000$100,000Taxes (40%)24,00040,000Net income$36,000$60,000Add back interest pa

53、id to bondholder40,000Total return to security holders (debt and equity)$76,00060,000Basic of Solvency Financial Leverage- Illustrating Tax Deductibility of Interest48Financial Leverage RatioGreater the proportion of financing from equity vs. debt lower the financial leverage ratioNote: Financial le

54、verage ratio is a component of the disaggregated return on equity see Chapter 8Basic of Solvency Financial Leverage49Potential accounts needing adjustments Chapter referenceDeferred Income Taxes Is it a liability, 3 & 6equity, or some of both?Operating Leases - capitalize non- 3cancelable operating

55、leases?OffBalanceSheet Financing3Pensions and Postretirement Benefits3Unconsolidated Subsidiaries5Contingent Liabilities3 & 6Minority Interests5Convertible Debt3Preferred Stock3Basic of Solvency Adjustments for Capital Structure - LiabilitiesBalance Sheet50Potential accounts needing adjustments Chap

56、ter referenceInventoriesLIFO Reserve?4Marketable Securities4Intangible Assets4 & 5Basic of Solvency Adjustments for Capital Structure - AssetsBalance Sheet51Projection of Future Cash Inflows and OutflowsReflects on risk for a levered companys capital structurePrepare a Statement of Forecasts of Cash

57、 Inflows and OutflowsCapital Structure and Solvency Long-Term ProjectionsChapter 10 described and illustrated long-term cash flow forecasts52Capital structure composition analysisPerformed by constructing a common-size statement of liabilities and equityReveals relative magnitude offinancing sources

58、Allows direct comparisons across different companiesTwo Variations(1) Use ratios, and (2) Exclude current liabilitiesCapital Structure and Solvency Common-Size Statements53Total Debt to Total Capital (also called total debt ratio)Capital Structure and Solvency Capital Structure Measures54Capital Str

59、ucture and Solvency Capital Structure MeasuresSource: Dun & Bradstreet55Total Debt to Equity CapitalReciprocal measure of this ratioEquity Capital to Total DebtCapital Structure and Solvency Capital Structure Measures56Long Term Debt to Equity Capital (also called Debt to Equity)Capital Structure an

60、d Solvency Capital Structure Measures57Capital Structure and Solvency Capital Structure MeasuresSource: Dun & Bradstreet58ShortTerm Debt to Total DebtEquity Capital at Market ValueCapital Structure and Solvency Capital Structure Measures59Commonsize and ratio analyses of capital structure mainly ref