Professional Documents
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Statement
Analysis
K.R. Subramanyam
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
10-2
Credit Analysis
10
CHAPTER
10-3
• Comparative Analysis
– Trend analysis
• Ratio Management (window dressing)
– Toward close of a period, management will occasionally press the
collection of receivables, reduce inventory below normal levels, and
delay normal purchases.
• Rule of Thumb Analysis (2:1)
– Current ratio above 2:1 - superior coverage of current liabilities (but not
too high - inefficient resource use and reduced returns)
– Current ratio below 2:1 - deficient coverage of current liabilities
• 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 company’s net trade cycle.
10-8
Illustration
Texas Electric’s current assets along with their common-size percentages
are reproduced below for Years 1 and 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
Cash $ 70,000
Accounts receivable 150,000
Inventory 65,000
Accounts payable 130,000
Notes payable 35,000
Accrued taxes 18,000
Fixed assets 200,000
Accumulated depreciation 43,000
Capital stock 200,000
Sales $750,000
Cost of sales 520,000
Purchases 350,000
Depreciation 25,000
Net income 20,000
(continued)
10-23
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 company’s stability
and solvency
• Debt financing
– Must be repaid with interest
– Specified repayment pattern
Basics of Solvency
Motivation for Debt
• From a shareholder’s perspective, debt is a
preferred external financing source:
– Interest on most debt is fixed
– Interest is a tax-deductible expense
• Financial leverage - the amount of debt
financing in a company’s capital structure.
– Companies with financial leverage are said to be
trading on the equity.
10-27
Basics of Solvency
Financial Leverage- Illustrating Tax Deductibility of Interest
10-28
Basics of Solvency
Adjustments for Capital Structure - Liabilities
Potential
Potentialaccounts
accountsneeding
needingadjustments
adjustments Chapter
Chapterreference
reference
•• Deferred
DeferredIncome
IncomeTaxes
Taxes--IsIsititaaliability,
liability, 33&&66
equity,
equity,or
orsome
someof ofboth?
both?
•• Operating
OperatingLeases
Leases--capitalize
capitalizenon-
non- 33
cancelable
cancelableoperating
operatingleases?
leases?
•• Off
Off‑Balance
‑Balance‑Sheet
‑SheetFinancing
Financing 33
•• Contingent
ContingentLiabilities
Liabilities 33&&66
•• Minority
MinorityInterests
Interests 55
•• Convertible
ConvertibleDebtDebt 33
•• Preferred
PreferredStock
Stock 33
10-29
Earnings Coverage
Earnings to Fixed Charges
Earnings Coverage
Earnings to Fixed Charges
10-35
Earnings Coverage
Times Interest Earned
Earnings Coverage
Earnings Coverage
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