Professional Documents
Culture Documents
11
CHAPTER
Liquidity and Working Capital
Basics
• Lower profitability
• Restricted opportunities
• Loss of owner control
• Loss of capital investment
• Insolvency and bankruptcy
Liquidity and Working Capital
Current Assets
Working capital is
defined as the excess of current assets over current
liabilities
Widely used measure of short-term liquidity
Deficient when current liabilities exceed current assets
In surplus when current assets exceed current liabilities
A margin of safety for creditors
A liquid reserve to meet contingencies and uncertainties
A constraint for technical default in many debt agreements
Liquidity and Working Capital
Working Capital
Current assets
Current ratio=
Current liabilities
Comparative Analysis
Examples are:
• Press the collection of
receivables at year-end
• Call in advances to officers for
temporary repayment
• Reduce inventory below normal
levels
• Delay normal purchases
$50,000
Inventorie s = = 56.24 days
$320,000 360
96.24 days
$20,000
Less : Accounts payable = = 30.00 days
$666.67
General merchandise
Educational services
Electrical equipment
Motion pictures
Food stores
360
Collection period=
Accounts receivable turnover
Operating Activity Analysis of Liquidity
Accounts Receivable Liquidity
Sales
Account Receivable
360
Operating Activity Analysis of Liquidity
Accounts Receivable Liquidity
Trend in:
Inventory Turnover
Ending inventory
Cost of average day' s sales
where the cost of average day’s sales is:
Selected financial information from Macon Resources, Inc., for the end of
Year 8 is reproduced below:
Sales
Cost of goods sold
Beginning inventory
Ending inventory
Inventory turnover ratios using average inventory are computed as:
Inventory turnover ratio =
$1,200,000
Cost of average day' s sales = $3,333
360
$400,000
Days' sales in inventory = 120 days
$3,333
Operating Activity Analysis of Liquidity
Inventory Turnover
Accounts payable
Days’ purchases in accounts payable =
Purchases 360
Composition of current
assets is an indicator of
working capital liquidity
Balance
Sheet
Use of common‑size
percentage comparisons
facilitates this analysis
Additional Liquidity Measures
Acid-Test (Quick) Ratio
General merchandise
Educational services
Electrical equipment
Printing and publishing
Motion pictures
Eating and drinking
Food stores
Focus of analysis:
• Ability to borrow from various
sources
• To raise equity capital
• To sell and redeploy assets
• To adjust the level and direction of
operations to meet changing
circumstances
• Levels of prearranged financing and
open lines of credit
Additional Liquidity Measures
Management’s Discussion and Analysis
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
Explanations:
(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 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).
Basic of Solvency
Facts
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
Leverage:
• Magnifies both managerial success (profits) and failure
(losses)
• Increases risks
• Limits flexibility in pursuing opportunities
• Decreases creditors’ protection against loss
Year 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. 1,000,000 1,000,000 200,000 80,000 120,000 120,000 12.0 12.0
Year 2:
Risky, Inc. 1,000,000 400,000 600,000 100,000 40,000 24,000 36,000 60,000 6.0 6.0
Safety, Inc. 1,000,000 1,000,000 100,000 40,000 60,000 60,000 6.0 6.0
Year 3:
Risky, Inc. 1,000,000 400,000 600,000 50,000 40,000 4,000 6,000 30,000 3.0 1.0
Safety, Inc. 1,000,000 1,000,000 50,000 20,000 30,000 30,000 3.0 3.0
* Tax rate is 40 percent.
† Return on assets = Net income + Interest (1 – 0.40)/Assets.
‡ Return on equity = Net income/Shareholders’ equity.
Basic of Solvency
Financial Leverage- Illustrating Tax Deductibility
of Interest
Inventories—LIFO Reserve? 4
Marketable Securities 4
Intangible Assets 4&5
Balance
Sheet
Capital Structure and Solvency
Long-Term Projections
Total debt
Total capital
Capital Structure and Solvency
Capital Structure Measures
General merchandise
Educational services
Electrical equipment
Printing and publishing
Motion pictures
Eating and drinking
Food stores
Long-term debt
Shareholders’ equity
Capital Structure and Solvency
Capital Structure Measures
General merchandise
Educational services
Electrical equipment
Motion pictures
Food stores
Asset Coverage
(a) Pre-tax income before discontinued operations, extraordinary items, and cumulative effects of accounting changes.
(b) Interest incurred less interest capitalized.
(c) Usually included in interest expense.
(d) Financing leases are capitalized so the interest implicit in these is already included in interest expense. However, the interest portion of long‑term
operating leases is included on the assumption many long‑term operating leases narrowly miss the capital lease criteria, but have many
characteristics of a financing transaction.
(e) Excludes all items eliminated in consolidation. The dividend amount is increased to pre‑tax earnings required to pay for it. Computed as [Preferred
stock dividend requirements]/[1 Income tax rate]. The income tax rate is computed as [Actual income tax provision]/[Income before income taxes,
extraordinary items, and cumulative effect of accounting changes].
(f) Applies to nonutility companies. This amount is not often disclosed.
(g) Minority interest in income of majority‑owned subsidiaries having fixed charges can be included in income.
(h) Included whether expensed or capitalized.
For ease of presentation, two items (provisions) are left out of the ratio above:
1. Losses of majority‑owned subsidiaries should be considered in full when computing earnings.
2. Losses on investments in less than 50‑percent‑owned subsidiaries accounted for by the equity method should not be included in earnings
unless the company guarantees subsidiaries’ debts.
Earning Coverage
Earnings to Fixed Charges - Illustration
C O M P U T E C H C O R P O R A T IO N
In c o m e S ta te m e n t
N e t s a le s $ 1 3 ,4 0 0 ,0 0 0
In c o m e o f le s s th a n 5 0 % -o w n e d a ffilia te s (a ll[n b ]u n d is tr ib u te d ) 6 0 0 ,0 0 0
T o t a l r e v e n u e $ 1 4 ,0 0 0 ,0 0 0
C o s t o f g o o d s s o ld $ 7 ,4 0 0 , 0 0 0
S e ll in g , g e n e r a l, a n d a d m in is tr a tiv e e x p e n s e s 1 ,9 0 0 , 0 0 0
D e p r e c i a ti o n (e x c lu d e d fr o m a b o v e c o s ts )3 8 0 0 , 0 0 0
In te r e s t e x p e n s e 1 — n e t 7 0 0 , 0 0 0
R e n ta l e x p e n s e 2 8 0 0 , 0 0 0
S h a r e o f m in o r ity in te r e s ts in c o n s o lid a te d in c o m e 4 2 0 0 , 0 0 0 1 1 ,8 0 0 ,0 0 0
In c o m e b e fo r e ta x e s $ 2 ,2 0 0 ,0 0 0
In c o m e ta x e s :
C u r r e n t $ 8 0 0 ,0 0 0
D e f e r r e d 3 0 0 ,0 0 0 (1 ,1 0 0 , 0 0 0 )
In c o m e b e fo r e e x tr a o r d in a r y ite m $ 1 ,1 0 0 , 0 0 0
E x tr a o r d in a r y g a in (n e t o f $ 6 7 ,0 0 0 ta x ) 2 0 0 , 0 0 0
N e t in c o m e $ 1 ,3 0 0 , 0 0 0
D i v id e n d s :
O n c o m m o n s to c k $ 2 0 0 ,0 0 0
O n p r e fe r r e d s to c k 4 0 0 ,0 0 0 6 0 0 ,0 0 0
E a r n in g s r e ta in e d fo r th e y e a r $ 7 0 0 ,0 0 0
S e le c t e d n o te s to t h e f in a n c ia l s t a te m e n ts :
1 In te r e s t e x p e n s e is c o m p o s e d o f t h e f o llo w in g :
In te r e s t in c u r r e d ( e x c e p t it e m s b e lo w ) $ 7 4 0 , 0 0 0
A m o r tiz a tio n o f b o n d d is c o u n t 6 0 , 0 0 0
In te r e s t p o r tio n o f c a p ita liz e d le a s e s 1 0 0 , 0 0 0
In te r e s t c a p it a liz e d (2 0 0 , 0 0 0 )
In te re s t e x p e n s e $ 7 0 0 , 0 0 0
2 In te r e s t im p lic it in n o n c a p it a liz e d le a s e s a m o u n ts to $ 3 0 0 ,0 0 0 .
3 D e p r e c ia tio n in c lu d e s a m o r tiz a tio n o f p r e v io u s ly c a p ita liz e d in te r e s t o f $ 8 0 ,0 0 0 .
4 T h e s e s u b s id ia r ie s h a v e fix e d c h a r g e s .
A d d it io n a l in f o r m a t io n ( d u r in g th e in c o m e s ta te m e n t p e r io d ) :
In c r e a s e in a c c o u n t s r e c e iv a b le $ 3 1 0 ,0 0 0
In c r e a s e in in v e n to r ie s 1 8 0 ,0 0 0
In c r e a s e in a c c o u n t s p a y a b le 1 4 0 ,0 0 0
D e c r e a s e in a c c r u e d t a x e s 2 0 ,0 0 0
E a r n in g s to fix e d c h a r g e s r a tio :
*
$ 2 ,2 0 0 (a ) $ 7 0 0 ( b a n d c ) $ 3 0 0 (d ) $ 8 0 (f ) $ 6 0 0 (g ) $ 2 0 0
2 .4 0
$ 8 4 0 (h ) $ 6 0 (c ) $ 3 0 0 (d )
* N o t e : T h e S E C p e r m it s in c lu d in g in in c o m e t h e m in o r it y in t e r e s t in t h e in c o m e o f m a jo r ity - o w n e d s u b s id ia r ie s h a v in g fix e d
c h a r g e s . T h is a m o u n t is a d d e d t o r e v e r s e a s im ila r d e d u c t io n f r o m in c o m e .
Earning Coverage
Tiimes Interest Earned
• Asset protection
• Financial resources
• Earning power
• Management
• Debt provisions
• Other: Company size, market share, industry position,
cyclical influences, and economic conditions
Rating Debt Obligations—Appendix 11A
Ratings and Yields
Percent
0 1 2 3 4 5 6 7
Treasury
AAA
AA
Altman Z-Score
LT D NFL
SE NDT LR MSA
LTD = Long‑term debt consisting of all long‑term liabilities inclusive of
(1) noncurrent deferred taxes likely to reverse, and (2) other
noncurrent liabilities.
NFL = Estimated present value of noncapitalized financial leases.
SE = Shareholders’ equity, including minority interests.
NDT = Noncurrent deferred taxes assessed as unlikely to reverse in the
foreseeable future.
LR = LIFO reserve (excess of disclosed FIFO value of
ending inventory over reported LIFO amount).
MSA = Excess of market value of marketable securities
over cost (for analysis of financial statements
prior to 1994).