Financial Statement

Analysis
Asset Conversion Cycle /
Company’s Operating Cycle
 The cash conversion cycle refers to the average length
of time between the payment for raw material purchased
and collection of cash for sales. The operating cycle is
related to the cash conversion cycle of a company.
 A company makes an investment in fixed assets and
current assets. The investment a company makes in
fixed assets, such as plants, machinery, land, and
buildings, is recovered after many years. Investment in
current assets, such as inventory, debtors, and accounts
receivable, is realized many times in a year. A company’s
investment in current assets is realized during its
operating cycle, which is usually less than a year.
Asset Conversion Cycle /
Company’s Operating Cycle
 The operating cycle refers to the purchase of
raw materials and the collection of cash for
sales.
 A firm begins with cash which then “becomes”
inventory and labor
 Which then becomes a product which is sold
 Eventually this will turn into cash again
 The firm’s operating cycle is the time from the
acquisition of inventory until cash is collected
from product sales
Working Capital Basics
 The assets/liabilities that are required to operate a
business on a day-to-day basis
 Cash
 Accounts Receivable
 Inventory
 Accounts Payable
 Accruals
 These assets/liabilities are short-term in nature and
turn over regularly
 Other Non-Trading Assets
 Other Non- Spontaneous Financing
Working Capital Basics
 Trading Assets
 Inventory
 AccountsReceivable
 Advance Payments (To Suppliers)
 Spontaneous Financing
 Accounts Payable
 Accrued Expenses
 Down Payments (Customers)
Working Capital Basics
________________________________
Working Investment
=
Trading Assets – Spontaneous Financing
____________________________________
Working Capital
=
Current Asset –Current Liabilities
____________________________________

Reflects the net amount of funds needed to support routine operations

Working Capital Basics
 To run the firm efficiently , little money as
possible should be tied up in Working
Investment and Working Capital
 Involves trade-offs between easier operation and the
cost of carrying short-term assets
 Benefit of low working capital
 Able to funnel money into accounts that generate a higher
payoff
 Cost of low working capital
 Risky
Working Capital Basics
Inventory
High Levels Low Levels
Benefit: Cost:
 Reduces stockouts and backorders  Shortages
 Makes operations run more smoothly, improves  Dissatisfied customers
customer relations and increases sales Benefit:
Cost:  Low storage costs
 Expensive (Interest on funds used to acquire inventory &  Less risk of obsolescence
 High storage costs
 Risk of obsolescence, Shrinkage and Spoilage

Cash
High Levels Low Levels
Benefit: Benefit:
 Reduces risk  Reduces financing costs
Cost: Cost:
 Increases financing costs  Increases risk
Working Capital Basics
Accounts Receivable
High Levels (favorable credit terms) Low Levels (unfavorable terms)
Benefit: Cost:
 Happy customers  Dissatisfied customers
 High sales  Lower Sales
Cost: Benefit:
 Expensive  Less expensive
 High collection costs
 Increases financing costs

Payables and Accruals

High Levels Low Levels
Benefit: Benefit:
 Reduces need for external finance--using a spontaneous  Happy suppliers/employees
financing source Cost:
Cost:  Not using a spontaneous financing
 Unhappy suppliers source
Inventory
 In early 2003, Ezz El Dekheila increased the steel spot prices in the local market
by more that 70% while blaming the international spot prices of raw materials
and final products as the main reasons for such increase. Customers and
politicians criticized El Dekheila for immediately rising the prices of steel. They
argued that the steel sold had been manufactured from Raw Materials purchased
post the price hikes, old Finished Goods Inventory in addition to the subsidized
manufacturing cost offered by the government as an incentive for local industries
and thus raising the prices of this “old” steel resulted in a windfall profit.
 El Dekheila counters that since the market price of steel and raw materials
“Bullets” had risen, replacing the old Bullets NOW cost more and thus raising the
price of steel was justified and reflective of current market conditions.
 The accounting choice of last-in, first-out (LIFO) versus first-in, first-out (FIFO)
for inventory and cost of goods sold (COGS) mirror this debate as to the more
appropriate measure of income.
 The choice affects the firm’s income statement, balance sheet and related ratios.
Perhaps more important, the decision has real cash flow effects as taxes paid by
the firm are affected by its choice of accounting method.
Inventory
Inventory and Cost of Goods Sold : Basic Relationship

 The inventory account is affected by two events: the purchase of goods “P”
and their subsequent sales (COGS). The relationship between these two
events and the balance of beginning inventory and ending inventory cab be
expressed as

EI=BI+P-COGS
Or
BI+P=COGS+EI

 For any period, prior to the preparation of the financial statements to the
period, the left side of the equation is known i.e. BI+P. preparation of the
income statement and the balance sheet for the period requires the
allocation of these costs (BI+P) between COGS and Ending Inventory.
Inventory
Example:
Beginning Inventory: 200 units @ LE 10/unit=LE 2,000

Scenario 1 Scenario 2
Quarter Unit Purchased unit Cost LE unit Cost LE
1 100 10 1000 11 1100
2 150 10 1500 12 1800
3 150 10 1500 13 1950
4 100 10 1000 14 1400
Total 500 5000 6250

Unit Sold : 100 unit per quarter for a total of 400 units
Ending Inventory : 300 units
Inventory
 Scenario 1

Since unit cost is constant,

COGS equals LE 4,000 (400*10)
and
Ending inventory equals LE 3,000 (300*10)
Inventory
 Using FIFO
The 400 unit sold are assumed to carry the earliest costs incurred and
the 300 units held in inventory carry the latest costs

COGS Ending Inventory

200@10= 2,000 50@12= 600
100@11= 1,100 150@13= 1,950
100@12= 1,200 100@14= 1,400
4,300 3,950
 Inventory
 Using LIFO
The 400 unit sold are assumed to carry the latest costs incurred and
the 300 units held in inventory carry the earliest costs

COGS Ending Inventory

100@14= 1,400 200@10= 2,000
150@13= 1,950 100@11= 1,100
150@12= 1,800 100@14=
5,150 3,100
Inventory

Weighted Average

Total Cost for the 700 units = 8,250

on a per unit basis , this results in a weighted average unit cost of

LE 8,250/700 =11.79

COGS 400X 11.79 =4,714

EI 300X 11.79 =3,536
Inventory
 Comparison of Information provided by
Alternative Methods
BI P = COGS EI
FIFO 2,000 6,250 = 4,300 3,950
Weighted Average 2,000 6,250 = 4,714 3,536
LIFO 2,000 6,250 = 5,150 3,100
Inventory
Balance Sheet Prospective

 Ending inventory consists of 300 units. At current replacement value (i.e. the
forth quarter unit cost of LE 14), the inventory would have a carrying value
of LE 4200 (300unit *LE 14 per unit).
 Ending inventory under FIFO (LE 3,950) comes closest to this amount as
FIFO allocated the earliest cost to COGS , leaving the most recent costs in
ending inventory.
 Conversely, LIFO balance of LE 3,100 is furthest from the current cost, as
LIFO accounting allocated the earliest (outdated) costs to ending inventory.
 Therefore, from the balance sheet prospective, During period of rising
prices inventories based on FIFO are preferable that those presented under
LIFO.

In other words, FIFO provides a measure of inventory that is

closer to its current (Economic)value.
Inventory
Income Statement Prospective

 Consider a situation where an item purchased for LE 6 is sold for

LE10 at a time when it cost LE 7 to replace it. Prior to replacement
of the item, reported income is LE 4 (LE 10-LE6). However, if
income is the defined as the amount available for distribution to
shareholders without impairing the firm’s operation, then it can be
urged that the effective income is only LE 3 as LE 7 (not the original
cost of LE 6) are needed to replace the item in inventory and
continue operations. The LE 1 difference between the original cost
of the item and the cost of replacement is referred to as a holding
again or inventory profit

Therefore, under the GAAP going concern assumptions, while the

economic income is LE 4 , the sustainable income is LE 3
Inventory
Income Statement Prospective

 To return to our example, assume that the company replaces its

inventory as soon as the inventory is sold , therefore the
replacement value is equal to LE 5000 as follows
Quarter Unit Sold unit Cost Replacement Cost
1 100 11 1100
2 100 12 1200
3 100 13 1300
4 100 14 1400
5000

 Therefore, During period of rising prices, LIFO is the most

informative accounting method for income statement purposes and
provides a better measure for current income and future profitability
Inventory
Ratio
Inventory turnover
Cost of Good Sold / (Average) Inventory
Measures the efficiency of the firm’s inventory
Management
(The Higher the Better)
 Inventory Days on Hand (DOH)
365/Inventory turnover
(The Lower the Better)
Inventory Analysis
 High level of Inventory
 ImportingRaw Materials
 Hedging against possible increase in prices
 Other…..

 Low Level of Inventory

Account receivable
Ratio
 Acc. Rec. turnover
Cost of Good Sold / (Average) Acc. Rec
Measures the efficiency of the firm’s Cash
Management
(The Higher the Better)
 Acc Rec. Days on Hand (DOH)
365/Acc. Rec. turnover
(The Lower the Better)
Account receivable
 Generally firms like as little money as possible
tied up in receivables
 Reduces costs (firm has to borrow to support the
receivable level)
 Minimizes bad debt exposure
 But, having good relationships with customers is
important
 Increases Sales
 Firm needs to strike a balance on these issues
Account Receivable
Analysis
 Objective: Maximize profitability (not Sales)
 Questions that need to be answered:
 Credit Policy—what type of customer will you lend to?
How financially viable must that customer be?
 Terms of sale (Trade)—What terms will the firm offer
to credit customers?
 Collections Policy—How will the firm collect from
those customers who don’t pay?
Account Receivable
Analysis
 Client Concentration
 Must examine the creditworthiness of potential credit
customers
 Credit report
 Customer’s financial statements
 Bank references
 Customer’s reputation among other vendors
 Aging Schedule
 Adequate provisions
Account Payable
Ratio / Analysis
Account Payable Turnover
COGS/(Average) Account Payable
 Account Payable DOH
(Average) Account Payable/COGS*365

 Concentration of Suppliers
Accrued Expenses
 Accrued Expenses Turnover
COGS/(Average ) Expenses

Accrued Expenses DOH


Accrued Expenses / COGS * 365
Working Investment
Working Investment
=
Trading Assets – Spontaneous Financing

Amount of monies that should be financed from outside the

cycle
On an absolute basis, working investment is directly related
to sales
Working Investment
Working Investment / Sales

The lower the better, why?

Better Account Receivable Collection
Better Inventory Management
Relies on Supplier Credit to Conduct the operating
Cycle
Ex: Carrefour & Metro
Plant / Net FA Turnover
 Sales/ Average Net Plant

-This Ratio may provides false information

-Asset Revaluation (SSC)
-Leased Asset (Capitalize)
-Appropriate measure for certain industries. Ex. Steel
Manufacturing and other capital intensive industries
-Un appropriate measure for other industries. Ex. Retailers
and Coffee shops
-therefore this ratio is used for capital intensive industries
only.
PMT 1500 7500
N 5
Rate 15%
PV ($5,028.23)
Repayment interest Pricip
5028.23 1500 754.2345 745.7655
4282.465 1500 642.3697 857.63033
3424.834 1500 513.7251 986.27487
2438.559 1500 365.7839 1134.2161
1304.343 1500 195.6515 1304.3485
-0.005324
Profitability
Sales Analysis-Example

 Sales
Sales

60,000 CAGR=26.62%
50,000

40,000
LE 000's

30,000

20,000

10,000

0
1997 1998 1999 2000 2001 2002 2003 2004 2005
Profitability
Sales Analysis-Example

Turn over per seat

1.80

1.70

1.60

1.50

1.40

1.30

1.20

1.10

1.00
1997 1998 1999 2000 2001 2002 2003 2004 2005
Profitability
Sales Analysis-Example

1.80
Decline phase
1.70

Average turnover per seat

1.60

1.50
Trend line

1.40

1.30

1.20

1.10

1.00
1997 1998 1999 2000 2001 2002 2003 2004 2005
Operating leverage
 Total Variable Costs vary with sales
 Variable Cost/Sales remain constant
 Fixed Costs do not vary with sales but
remain constant regardless of how much
the company produce or sale (Rent,
Depreciation and other overhead)
Operating leverage
 Breakeven point
Quantity Sold=Total Variable Cost +Fixed Cost
Example

Company A Company B
Variable Cost per unit 1.5 1.5
Fixed Cost 5000 7000
Sales Price per unit 2.75 2.75
break Even Q 4000 5600
Operating Leverage
Company A
30000 Company A Sales Revenue

25000 Breakeven Q = 4000

20000

15000 Total Cost

10000
Fixed Cost
5000

0
0 1000 2000 3000 4000 5000 6000 7000 8000 9000 10000
Operating Leverage
Company B
30000 Company A Sales Revenue
Breakeven Q = 5600
25000

20000

15000 Total Cost

10000
Fixed Cost
5000

0
0 1000 2000 3000 4000 5000 6000 7000 8000 9000 10000
 Example

General Assmptions Company V Company F

Fixed Cost 0 40
Variable Cost 80% 40%
Assets 200 200

Assume 0% Financing, Debt=0, Equity=200

No Leverage
No leverage
Company V
Scenario A B C
Sales 50 100 150
variale Cost 40 80 120
FC
net Income 10 20 30

Return
on sales 20% 20% 20%
on assets 5% 10% 15%
on equity 5% 10% 15%
Operating Leverage
Operating leverage
Company F
Scenario A B C
Sales 50 100 150
variale Cost 20 40 60
FC 40 40 40
net Income -10 20 50

Return
on sales -20% 20% 33%
on assets -5% 10% 25%
on equity -5% 10% 25%
 Financial Leverage
Assume 50% Financing , Debt=100 Equity =100, Interest Rate=5%

Financial leverage
Company V
Scenario A B C
operating Income 10 20 30
Interest 5 5 5
net Income 5 15 25

Return
on Assets 3% 8% 13%
on equity 5% 15% 25%
 Financial Leverage
Assume 50% Financing , Debt=100 Equity =100, Interest Rate=5%

Financial leverage
Company F
Scenario A B C
operating Income -10 20 50
Interest 5 5 5
net Income -15 15 45

Return
on Assets -8% 8% 23%
on equity -15% 15% 45%
Financial Leverage
 Given that increases in financial leverage
increase ROE, why are all companies not
100% debt financed?
 The answer is because debt is risky. This
increased risk increases the expected
return that investors require to provide capital
to the firm.
 Higher financial leverage also results in a
higher interest rate on the company’s debt.
 Sales Analysis- CSD
Historical Adjusted
2002 2003 2004 2005 2002 2003 2004 2005
Sales LE 000s 128,874 111,052 96,942 121,683 128,874 111,052 96,942 121,683
Sales Growth 21.91% -13.83% -12.71% 25.52% 21.91% -13.83% -12.71% 25.52%
COGS/SALES 54.55% 56.72% 60.74% 66.41% 54.55% 56.72% 60.74% 66.41%
EBITDA LE 000s 23,821 17,570 15,463 8,247 27,576 21,325 19,218 8,247
EBITDA Margin 18.48% 15.82% 15.95% 6.78% 21.40% 19.20% 19.82% 6.78%
EBIT 14,531 9,155 7,167 2,057 16,704 11,327 9,340 476
EBIT Margin 11.28% 8.24% 7.39% 1.69% 12.96% 10.20% 9.63% 0.39%
Net Income LE 000s 3,737 229 (583) (6,690) 4,328 1,255 963 (8,272)
ROS 2.90% 0.21% -0.60% -5.50% 3.36% 1.13% 0.99% -6.80%
ROE 9.56% 0.68% -1.81% -8.04% 11.16% 3.60% 2.67% -9.07%
 WI Analysis- CSD

2002 2003 2004 2005 2002 2003 2004 2005

Working Investment LE 000's 854 (1,909) 12,695 41,755 854 (1,909) 12,695 41,755
WI/ Sales 0.7% -1.7% 13.1% 34.3% 0.7% -1.7% 13.1% 34.3%
Net Plant Turnover 1.20 1.08 1.01 0.89 1.17 1.03 0.97 0.88
 Example AMIANTIT
2002 2002 2003 2004

Sales SR 000s 1,077,420 1,219,026 1,621,631 1,856,768

Operating Rates
Sales Growth #DIV/0! 13.14% 33.03% 14.50%
Cash COGS/SALES 63.84% 66.22% 69.42% 75.88%
COGS/SALES 67.87% 70.21% 73.19% 79.88%
EBITDA SR 000s 233,179 219,069 201,846 120,536
EBITDA Margin 21.64% 17.97% 12.45% 6.49%
EBIT 183,750 158,926 119,495 20,820
EBIT Margin 17.05% 13.04% 7.37% 1.12%
Net Income SR 000s 120,488 104,080 78,330 (52,963)
ROS 11.18% 8.54% 4.83% -2.85%
ROE 18.17% 13.56% 9.50% -6.71%
Example AMIANTIT

90%
80% COGS/Sales
70%
60%
50%
40% GP M

30% EB ITDA M argin

20% EB IT M argin
10%
ROS
0%
-10% 2001 2002 2003 2004
 Example AMIANTIT

2001 2002 2003 2004

Working Investment SR 000's 878,204 940,365 1,087,473 1,098,066
WI/ Sales 81.51% 77.14% 67.06% 59.14%
Net Asset Turnover 0.60 0.50 0.52 0.54
 Example AMIANTIT

2001 2002 2003 2004

A/R DAYS ON HAND 268.93 256.80 217.97 193.20

RM DOH 73.96 75.20 60.67 57.98
WIP DOH 0.00 0.00 10.84 21.98
FG DOH 43.24 57.12 66.42 62.19
GIT DOH 33.39 30.01 19.15 23.65

DUE FROM SISTER CO (ST) DOH 16.52 11.19 20.83 15.60

A/P DAYS ON HAND 96.70 116.95 102.08 98.22
A/E DAYS ON HAND 8.89 6.36 6.11 9.12
DOWN PAYMENTS DOH 1.85 2.16 4.41 6.94
DUE TO SISTER CO (ST) DOH 11.83 8.04 6.87 16.06
Analysis of Investment Activities
Investment Income
Classification of Investment depends primarily
on the degree of influence or control over the
investee
Investment

<20% 20%-50% >50%

No Significant Control Significant Control Control

Traded Equity Method Consolidation

Analysis of Traded Security
Investment Income
Accounting Methods

Over the life of an investment, the total

return earned on the investment equal:

Dividends Received + Capital Gain (loss)

Investment Income

All methods used to report the investment

in securities recognize dividends as part of
the income in the year they are earned.
They differ as to when changes in the
market value of the assets are recognized
Investment Income
Accounting Methods
We have three methods:
1. The Cost Method: recognizes price changes
only in the period the security is sold.

2. The Market Method: mirror the actual economic

performance of the security and recognizes
price changes in the period they occur
Investment Income
Accounting Methods
3. Lower of Cost or Market :”LOCOM”

Recognizes price changes prior to sales

ONLY when the market values declines
below original value
Investment Income
Accounting Methods-Example
 Company P purchases 1 share of company S for
LE 100
 Company S reports net income of LE 25 per
share for period 1 a declare a dividend of LE per
share
 The market value for share S rises to LE 135 at
the end of period 1
 Company P sells its share of Company S for LE
120 during period 2
Investment Income
Accounting Methods- Cost Method
 Under the cost method, asset are recorded at
their cost
 At Acquisition:
Investment in company S LE 100
 Income Statement at the end of period 1
Dividend Received LE 100
 Income Statement at the end of period 2
Investment Income (realized gain) LE 20 (LE120-
LE 100)
Investment Income
Accounting Methods- Market Method
 Under the Market Method, securities are carried
at their market value.i,e unrealized changes in
the market value are included in net income
along with dividends received
 Total Return for Period 1 is composed of
dividend received plus the unrealized capital
gain
=10+35 (LE 135-LE 100)=LE 45
Therefore the new carrying value of the investment
is LE 135
Investment Income
Accounting Methods- Market
Method
 When the Investment is sold during period
2, Company P recognizes the difference
between the selling price and the new
carrying value
 i.e realized gain (loss)= Selling price-
Carrying value
=LE 120-LE 135=(15)
Investment Income
Accounting Methods- Market
Method

The Market Method reflects the actual

economic return earned on the investment
in each period
Investment Income
Accounting Methods- LOCOM
 Takes a conservative approach and
recognizes unrealized losses (not Gain)
and recoveries of previously recognized
unrealized losses
 Therefore, during period 1 , the company
will recognize dividend received and
during period two, the company will
recognize the capital gain of LE 20
Investment Income
Accounting Methods-Summary
Method Balance sheet carrying value Income Statement

Cost Cost Dividend Received

Realized gains and losses

Market Market Dividend Received

Realized and Unrealized gains and Losses

LOCOM LOCOM Dividend received

Realized gains and losses
unrealized losses and recoveries
Investment Account
Traded Security
Traded

No Yes

Cost Method Trading Available for Sale Held to Maturity

Investment Account
Trading Securities
The market method is used for Trading
Securities “Securities held for trading”
 Balance Sheet: the current market value
 Income Statement: Dividend received plus
all gain (losses) realized and unrealized
Investment Account
Held for Maturity
The cost method is used to report
investment classifies as held for maturity
 Balance sheet: historical value
 Income Statement: Dividend Received
plus realized gains (losses)
Investment Account
Available for Sale
 Balance Sheet:
The market method is used to report carrying
value on the balance sheet ”Fair Market Value”
 Income Statement
The cost method is used to report dividend
received and realized gains (losses)
Unrealized gains (losses) are reported as a
separate component in the shareholders equity
 Sum up
Classification Balance sheet carrying value Income Statement

Held to Maturity Cost Dividend Received

Realized gains and losses

Available for Sale Market Dividend Received

Realized gains and Losses
Unrealized gains and losses in shareholders equity

Trading Market Dividend received

Realized gains and losses
unrealized losses and recoveries
 Investment

<20% 20%-50% >50%

No Significant Control Significant Control Control

Traded Equity Method Consolidation

No Yes

Cost Method Trading Available for Sale Held to Maturity

Example

No. of Shares Cost/Share Total Cost M. Price/Share Market Value

2003 100 80 8000 70 7000
2004 70 80 5600 80 5600
70 80 5600 90 6300
40 70 2800 90 3600
2005 8400 9900
 Held to Maturity
Dividend Received Realized Gain Realized loss Unrealized gain Unrealized loss Total
2003 200 0 0 0 0 200
2004 140 0 -600 0 0 -460
2005 220 0 0 0 0 220

Balance sheet Carrying Value

2003 8000
2004 5600
2005 8400
 Available for Sale
Dividend Received Realized Gain Realized loss Unrealized gain Unrealized loss Total
2003 200 0 0 0 0 200
2004 140 0 -600 0 0 -460
2005 220 0 0 0 0 220

Balance sheet Carrying Value

2003 7000
2004 5600
2005 9900
 Trading Securities
Dividend Received Realized Gain Realized loss Unrealized gain Unrealized loss Total
2003 200 0 0 0 -1000 -800
2004 140 0 -300 700 0 540
2005 220 0 0 1500 0 1720

Balance sheet Carrying Value

2003 7000
2004 5600
2005 9900
Trading Securities
 Reported profit can be manipulated through
reclassification.
 Unrealized gains/losses reduce the quality of
earnings (increase the difference between CFO
and Net Income)
 Unrealized gains/losses should be eliminated
when calculating profitability ratios
 Unrealized gains/losses may be added when
calculating leverage and capital structure ratios
Equity method of Accounting
 Used when the investor exercise a significant
control over the investee.
 The investor reports its proportionate share of
the investee’s net assets ”equity” and recognize
a proportionate share of the income of the
investee
 Dividend received reduces the carrying value of
the investment
 Gains/losses are recognized only when realized
 Equity Method
Re: Example

No. of Shares Cost/Share Total Cost M. Price/Share Market Value

2003 100 80 8000 70 7000
2004 70 80 5600 80 5600
70 80 5600 90 6300
40 70 2800 90 3600
2005 8400 9900
Equity Method
Earning in the equity of the investee Realized losses
2003 700 0
2004 560 -750
2005 770 0

Balance sheet Carrying Value

2003 8500
2004 6370
2005 9720

Changes in the market value of the investment is not recognized

under the equity method unless there is a permanent impairment
Equity Method
analysis
 When the investee is profitable, the equuity method will
report favorable results as long as dividend payout is
less than 100%
 Interest coverage ratio, return ratios will be improved
 The investor recognize the proportionate share of the
investee’s income without any recognition of the
investee’s debt, therefore leverage ratios will be
improved under the equity method
 NOTE: as assets and equity increase, if the investee’s
profitability decline, the return ratio of the investor may
be adversely affected.
Equity Method
analysis
 Therefore, equity earning must be
adjusted by including actual dividends
received in the income of the Investor
“parent”
Consolidation
 Under consolidation, minority interest
equal the proportionate share of the
minority in the equity of the subsidiary less
dividend paid
 Minority interest should be considered as
a liability and included in the long term
liability when calculating the leverage
ratios
Interest Expense
 The ratio of interest expense to average funded debt
gives a rough indication to the interest rate a company is
paying.
 Changes in interest rate to average funded debt indicate
changes in the type of debt the company is taking or
changes in average rate charges
 If interest rate indicated by the ratio is unreasonably high
in comparison to the prevailing interest rates, it may
indicate that the company is using short-term financing
which has paid back before the financial statements
were drawn up.
Interest Expense
 A frequently used measure of a company's ability
to cover its interest payments is its earnings
before interest and taxes and before depreciation
and amortization (EBITDA) to its interest expense.
A company is financially distressed whenever its
EBITDA is less than its interest expense.
EBITDA
Time Interest Earned 
InterestExpense
Credit Risk and Capital Structure

 Credit risk refers to the ability and willingness of a borrower to

pay its debt.

 Ability to repay debt is determined by capacity to generate cash

from operations.

 Willingness to pay depends on which competing cash need is

viewed as the most pressing at the moment.

 The statement of cash flows is an important source of

information for analyzing a company’s credit risk. Financial
ratios are also useful for this purpose.
Credit Risk and Capital Structure

Credit risk analysis using financial

ratios typically involves an
assessment of liquidity and
solvency
Liquidity vs. Solvency
Liquidity is a firm’s ability to meet its current
Obligations. i,e the firm’s ability to generate cash
from operation “internally”
whereas solvency is a firm’s ability to meet all its
maturing obligations as they come due ”from
internal or external sources”, without losing the
ability to continue operations.
Liquidity
Liquidity is the ability of the company to
meet its maturing obligations with its
available cash or near cash resources

Liquidity is mainly related to the analysis of

the company working investment. i.e
operating cycle.
Liquidity

For assets other than money, liquidity describes

how quickly an asset can be converted into cash
and the certainty associated with the conversion
ratio, or price, which will be realized for the
asset.

Conversely, for liabilities, liquidity describes how

quickly obligations will have to be paid in cash
and whether the obligations can be paid at less
than their full stated repayment amount.
Liquidity
To evaluate liquidity, each of the assets and liabilities on a
company's balance sheet should be evaluated for liquidity. Current
assets are those which will likely be converted to cash within one
year or less. Current liabilities are those which must be paid within
one year. However, when a company becomes financially
distressed, even assets which are normally considered current
assets (accounts receivable and inventories, for example) may
become relatively illiquid. Long-term assets, in general, are far less
liquid than current assets. Some longer term assets may be very
illiquid. Also, as stated above, often a company's long-term liabilities
can become immediately due and payable if the company violates
contractual debt covenants or other obligations.
Liquidity
 Frequently used liquidity measures
include: a) working capital (current
assets minus current liabilities), 2) current
ratio (current assets divided by current
liabilities), and 3) quick ratio (cash,
marketable securities and accounts
receivable divided by current liabilities).
Working Capital

Working Capital
Current Assets - Current Liabilitie s
Working Capital
Working capital represents a cushion or
margin of protection for current creditors

i.e. current assets could “Shrink” from their

stated value by the amount of working
capital before current creditors would incur
a loss
Working Capital
 Analysis of working capital is directly
related to the analysis of working
investments.
 Special consideration should be given to
the quality of current assets “ more
particularly the quality of account
receivable and inventory”
Current ratio
Current Assets
Current Ratio 
Current Liabilitie s

Analysis of this ratio must consider the quality of

Current Assets, mainly inventory (obsolesces )
and Acc. Receivable (ageing schedule,
creditworthiness of the debtors)
Current ratio
Calculus trap
 When the ratio is greater than one, equal
increase in both CA and CL will decrease
the ratio
 When the ratio is lower than one, equal
increase in CA and CL will increase the
ratio
Current Ratio
 Current ratio is subject to window dressing.
Example, the company may repays its revolving
credit lines just prior to the financial closing date
to improve the ratio.
∴A disadvantage of the current ratio is that it
uses year-end balances of current assets and
current liabilities (may not be representative of
a company's position during most of the year.)
Better Ratio:
Current Cash Debt Coverage Ratio
 A ratio that partially corrects this is the current
cash debt coverage ratio.
Cash flow from operations
Average current liabilities
Since cash from operations involves the entire
year rather than a balance at one point in time, it
is often considered a better representation of
liquidity on the average day.
Quick Ratio

Cash  Marketable
Cash Securities  Receivable
Marketable Securities Receivable ss
Quick Ratio 
Quick Ratio
Current
Current Liabilitie
Liabilitie ss

Inventory is eliminated, providing a more

short-run reflection of liquidity,
since few businesses can instantaneously
convert their inventories into cash.
Liquidity
and Asset Efficiency Ratios
 The improvement in Asset efficiency ratios
may indirectly indicate that the company
are becoming more liquid over time.
 Inventory Reliance Ratio
 Note: the ratio is written wrongly in your notes
Inventoryreliance ratio

Current Liabilities -(Cash  Marketable Securities  Receivables)


Inventory

 The ratio indicates the min. percentage of inventory that

must be converted to cash to payout current creditor after
cash, Marketable Securities and Acc. Receivable have
been liquidated. The ratio assume full collection of
account receivable and sale of Marketable securities at
book value
Solvency
 The aim of long-term solvency analysis is
to detect early signs that a company is
headed for financial difficulty
 Decliningprofitability and liquidity ratios
 Unfavorable debt to equity ratio
 Unfavorable interest coverage ratio
Solvency
Leverage
Total Liabilitie s

Total Tangible Networth
Solvency
Debt to Equity Ratio
Total Debt

Total Tangible Networth
 Gives some idea of the riskiness of the firm,
however, the debt ratio tends to be a function of
the industry. Low for retailers and high for heavy
industries
Solvency
 A measure of solvency that uses cash figures is
the cash debt coverage ratio.
Cash flow from Operations
Average Total Liabilities

 This ratio shows the ability of a company to generate

cash flows from operations in order to service both short-
term and long-term borrowings.
Solvency
 Interest coverage ratio
 While debt ratios are useful for understanding the
financial structure of a company, they provide no
information about its ability to generate a stream of
inflows sufficient to make principal and interest
payments. The interest coverage ratio is commonly
used for this purpose.

 Measure of creditors’ protection from default on

interest payments
 Solvency
Two Important Ratios

EBITDA
Times Interest Earned 
InterestExpense

Income Before Income Taxes  Interest Expense

Interest Coverage Ratio 
Interest Expense
Appropriate Capital Structure
Tradeoff between cost and risk

 The capital structure mix is a tradeoff

between cost and risk and, as a result,
debt and equity.
 Debt typically has a lower cost than
equity, although the incremental cost of
debt will increase as the amount of debt in
the capital structure increases.
Appropriate Capital Structure
Tradeoff between cost and risk

 Debt requires a contractual repayment of

principal and interest and has priority
over common dividend payments.
Failure to meet those contractual
obligations means default, penalties and
perhaps the loss of property and other
assets to creditors.
Appropriate Capital Structure
Tradeoff between cost and risk
 Payments to equity holders are not contractually
committed. If the capital structure contained
only common stock and cash flows were not
sufficient to pay a dividend to common
shareholders, common shareholders could not
force bankruptcy.
 To accept the uncertainty of dividends, as well
as an uncertain future investment value
associated with common stock, shareholders
expect to earn a higher return than bondholders.
Appropriate Capital Structure
Tradeoff between cost and risk
 Generally speaking, the greater the percentage of equity
in the capital structure, the higher the Company’s rating,
and the greater the ease of access to the capital
markets. The cost of this relatively higher equity
component is a higher absolute after-tax cost of capital
for the Company. Conversely, the more relative debt in
the capital structure (assuming it stays within reasonable
bounds), the lower the after-tax cost of capital for the
Company. While the absolute costs may be lower, the
benefits might be illusory because with the lower bond
ratings, the Company’s access to capital market could
be restricted.
Appropriate Capital Structure
Tradeoff between cost and risk

 The appropriate levels of debt in a capital

structure should be a function of the
Company’s cash flow “ Tenor Matching”
and its ability to pay the interest costs
associated with that debt in addition to the
Risk inherent in the company’s operation
” Business Risk”.
Appropriate Capital Structure
Tradeoff between cost and risk
General Rule

 As a general rule, the more consistent and

predictable the Company’s cash flow, the more
debt it can support in its capital structure.
 Utilities possess generally stable cash flow
patterns and typically have a greater amount of
debt than an industrial company with
comparable risk characteristics. The opposite of
a utility company might be an internet service
provider wherein customers can and do change
service providers at a moment’s notice.
Appropriate Capital Structure
Tradeoff between cost and risk

 Two Criteria governs the appropriateness

of the company’s Capital Structure
1-Tenor Matching
2-Business Risk
Appropriate Capital Structure
Tenor Matching
 General Rule:
The Tenor of Financing should match the
tenor of the Assets being financed.
Short term financing should support short
terms need and long term financing should
support long term need.
Appropriate Capital Structure
Short term Financing
 Short term financing is required to finance
temporarily shortfall in cash due from the
company’s operating cycle. i.e the
mismatch between trading assets DOH
and Spontaneous financing DOH.
 Short term financing is also required to
finance seasonal peaks in the company’s
operating cycle
 Appropriate Capital Structure
Short term Financing
Working Capital
Net C. Asset –C. Liabilities
Working Current
Capital liabilites Working Investment
Current Trading Assets –Spontaneous Financing.
assets
Ignoring cash and all non operating assets and
Long-term
debt liabilities,

working capital
Trading Assets-Spontaneous financing-STD
Fixed
Or
assets
Shareholders’
equity
Working Investment-STD
Or

The investment in current assets that is financed

by permanent fund.
Appropriate Capital Structure
Short term Financing
 In analyzing short term financing, special
consideration should be given to the business risk
associated with the company’s operating cycle.
Remember the story of sand truck in Cairo-
Alexandria high way.
 Another factor to consider is the permanent
investment in Assets.
 Business risk should be absorbed by Equity owners.
 Permanent level of working capital “investment”
should be financed by Equity owners and/or long
term debt. Why?
Appropriate Capital Structure
Company

Short term Long term

Investment Investment

WI Long term
Assets

STD Permanent
Fund

STD LTD Equity

“Revolving”
 Appropriate Capital Structure
Example

Cash 85 Acc. Payable 200

ACC. Rec 735 Accrued Expenses 155
Inv. 1,065 N/P 800
Div. Payable 500
Current Assets 1,885 Current Liabilities 1,655

Plant 915 Equity 1,145

Total Current Assets 2,800 Total Equit and Liabilities 2800

Appropriate Capital Structure
Example
 The permanent level of working investment is
20%
 The firm has a history of not being able to collect
10% of its Account Receivable
 The quality of inventory is such that in liquidation
the net realizable value would be 30% of the
value state on the balance sheet
 The notes payable listed on the balance sheet
represents what the company is currently using
of a LE 1400 line of credit from its bank