Ch 10 - Credit Analysis

Chapter 10 - Credit Analysis Analysis

Chapter 10 Credit Analysis REVIEW This chapter focuses on credit analysis. It is separated into two major sections li!uidity analysis and sol"ency analysis. #i!uidity refers to the a"aila$ility of resources to meet short%term cash re!uirements. A company&s short%term li!uidity ris' is affected $y the timin( of cash inflows and outflows alon( with its prospects for future performance. )ur  analysis of li!uidity is aimed at companies& operatin( acti"ities* their a$ility to (enerate profit profits s from from the sale sale of (oo (oods ds and ser"ic ser"ices* es* and wor'in wor'in( ( capita capitall re!uir re!uireme ements nts and measures. This chapter descri$es se"eral financial statement analysis tools to assess short%term li!uidity ris' for a company. We $e(in with a discussion of the importance of  li!uidity and its lin' to wor'in( capital. We e+plain and interpret useful ratios of $oth wor'in( capital and a company&s operatin( cycle for assessin( li!uidity li!uidity.. We also discuss potential potential adjustments adjustments to these analysis analysis tools tools and the underlyi underlyin( n( financial financial statement num$ers. What%if analysis of chan(es in a company&s conditions or strate(ies concludes this section. The second part of this chapter considers sol"ency analysis. ,ol"ency is an important facto factorr in ou ourr anal analys ysis is of a comp compan any& y&s s fina financ ncia iall stat statem emen ents ts.. ,ol" ,ol"en ency cy refer refers s to a company&s lon(%run financial "ia$ility and its a$ility to co"er lon(%term o$li(ations. All $usi $u sine ness ss acti acti"i "iti ties es of a comp compan anyy-fi fina nanc ncin in(* (* in"e in"est stin in(* (* and and op oper erat atin in((-af affe fect ct a company&s sol"ency. )ne of the most important components of sol"ency analysis is the composition of a company&s capital structure. Capital structure refers to a company&s source sources s of financ financin( in( and its econo economic mic attri$u attri$utes tes.. Thi This s chapte chapterr descri descri$es $es capita capitall structure and e+plains its importance to sol"ency analysis. ,ince sol"ency depends on success success in operatin( operatin( acti"ities* acti"ities* the chapter e+amines e+amines earnin(s earnin(s and its a$ility a$ility to cover  important important and necessary necessary company company e+penditur e+penditures. es. ,pecifical ,pecifically ly** this chapter descri$es descri$es "arious tools of sol"ency analysis* includin( le"era(e measures* analytical accountin( adju adjust stme ment nts* s* capi capita tall stru struct ctur ure e anal analys ysis is** and and earn earnin in(s (s%c %co" o"er era( a(e e meas measur ures es.. We demonstrate these analysis tools with data from financial statements. We also discuss the relation $etween ris' and return inherent in a company&s capital structure* and its implications for financial statement analysis.

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Chapter 10 - Credit Analysis Analysis

)T#I/E ,ection 1 #i!uidity #i!uidity •

#i!uidity and Wor'in( Capital  Current Assets and #ia$ilities Wor'in( Capital easure of #i!uidity Current Ratio easure of #i!uidity sin( the Current Ratio for Analysis Cash%ased Ratio easures of #i!uidity

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)peratin( Acti"ity Analysis of #i!uidity Accounts Recei"a$le #i!uidity #i!uidity easures In"entory Turno"er easures #i!uidity of Current #ia$ilities

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Additional #i!uidity easures Current Assets Composition Acid%Test 23uic'4 Ratio Cash 5low easures 5inancial 5le+i$ility ana(ement&s 6iscussion and Analysis

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What%If Analysis

,ection 7 Capital ,tructure and ,ol"ency •

Importance of Capital ,tructure Characteristics of 6e$t and E!uity oti"ation for 6e$t Capital Concepts of 5inancial #e"era(e Adjustments for Capital ,tructure Analysis

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Capital ,tructure Composition and ,ol"ency Common%,i8e Common%,i8e ,tatements in ,ol"ency Analysis Analysis Capital ,tructure easures for ,ol"ency Analysis Analysis Interpretation of Capital ,tructure easures Asset%ased Asset%ased easures of ,ol"ency

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Chapter 10 - Credit Analysis Analysis

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Earnin(s Co"era(e Relation of Earnin(s to 5i+ed Char(es Times Interest Earned Analysis Relation of Cash 5low to 5i+ed Char(es Earnin(s Co"era(e of 9referred 6i"idends 6i"idends Interpretin( Earnin(s Co"era(e easures

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Capital ,tructure Ris' and Return

Appendi+ 11A Ratin( 6e$t Appendi+ 11 9redictin( 9redict in( 5inancial 6istress

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Chapter 10 - Credit Analysis Analysis

A/A#: A/A#:,I, );ECTIVE, );ECTIVE, •

E+plain the importance of li!uidity in analy8in( $usiness acti"ities. acti"ities.

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6escri$e wor'in( capital measures of li!uidity li!uidity and their components.

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Interpret the current ratio and cash%$ased measures of li!uidity. li!uidity.

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Analy8e Analy8e operatin( cycle and turno"er measures of li!uidity li!uidity and their interpretation.

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Illustrate Illustrate what%if analysis for e"aluatin( chan(es in company conditions and policies. 6escri$e capital structure and its relation to sol"ency. sol"ency. E+plain financial le"era(e and its implications implications for company performance and analysis. Analy8e Analy8e adjustments to accountin( acc ountin( $oo' "alues to assess capital structure. 6escri$e analysis tools for e"aluatin( and interpretin( capital structure composition and for assessin( sol"ency.

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Analy8e Analy8e asset composition composition and co"era(e for sol"ency analysis.

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E+plain earnin(s%co"era(e analysis and its rele"ance in e"aluatin( sol"ency. sol"ency.

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6escri$e capital structure ris' and return and its rele"ance to financial statement analysis.

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Interpret ratin(s of or(ani8ations& de$t o$li(ations 2Appendi+ 11A4.

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6escri$e prediction models of financial distress 2Appendi+ 114.

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Chapter 10 - Credit Analysis Analysis

3E,TI)/, 1. #i!uidi #i!uidity ty is an indicator indicator of an entity&s entity&s a$ility a$ility to meet its current o$li(ati o$li(ations. ons. An An entity in a wea' short% short%ter term m li!uid li!uidity ity po posit sitio ion n wil willl ha"e ha"e diffic difficul ulty ty in meetin meetin( ( short%t short%term erm o$li(ations. This has implications for any current and potential sta'eholders of a company company.. 5or e+ample* e+ample* lac' of li!uidi li!uidity ty would would affect users< users< analysis analysis of financial financial statements in the followin( followin( ways Equity investor  In this case* the company li'ely is una$le to a"ail itself of fa"ora$le discounts and to ta'e ad"anta(e of profita$le $usiness opportunities. It could e"en mean loss of control and e"entual partial or total loss of capital in"estment. Creditors In this case* delay in collection of interest and principal due would $e e+pected and there is a possi$ility of the partial or total loss of the amounts due them. 7. A major major limitati limitation on in usin( usin( wor'in( wor'in( capital 2in dollar dollars4 s4 as an analysis analysis measure measure is its failure to meanin(fully relate it to other measure for interpreti"e purposes. That is* wor'in( capital is much more meanin(ful when related to other amounts* such as current current lia$iliti lia$ilities es or total assets. In addition* addition* the importance importance attached to wor'in( capital $y "arious users pro"ides a stron( incenti"e for an entity 2especially the ones in a wea' financial position4 to stretch stretch the definition of its components. 5or e+ample* some mana(ers may =e+pand> the definition of what constitutes a current asset and a current lia$ility to $etter present their current position in the most fa"ora$le li(ht. oreo"er* there are se"eral opportunities for mana(ers to stretch these definitions. 5orr this 5o this reaso reason* n* the the anal analys ystt mu must st use use jud( jud(men mentt in e"al e"alua uati tin( n( mana mana(e (emen ment< t