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Chapter 11

Credit Analysis

REVIEW

This chapter focuses on credit analysis. It is separated into two major sections: liquidityanalysis and solvency analysis. Liquidity refers to the availaility of resources to meetshort!term cash requirements. " company#s short!term liquidity ris$ is affected y thetimin% of cash inflows and outflows alon% with its prospects for future performance. &uranalysis of liquidity is aimed at companies# operatin% activities' their aility to %enerateprofits from the sale of %oods and services' and wor$in% capital requirements andmeasures. This chapter descries several financial statement analysis tools to assessshort!term liquidity ris$ for a company. We e%in with a discussion of the importance ofliquidity and its lin$ to wor$in% capital. We e(plain and interpret useful ratios of othwor$in% capital and a company#s operatin% cycle for assessin% liquidity. We also discusspotential adjustments to these analysis tools and the underlyin% financial statementnumers. What!if analysis of chan%es in a company#s conditions or strate%ies concludesthis section.

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The second part of this chapter considers solvency analysis. )olvency is an importantfactor in our analysis of a company#s financial statements. )olvency refers to acompany#s lon%!run financial viaility and its aility to cover lon%!term oli%ations. "llusiness activities of a company*financin%' investin%' and operatin%*affect acompany#s solvency. &ne of the most important components of solvency analysis is thecomposition of a company#s capital structure. +apital structure refers to a company#ssources of financin% and its economic attriutes. This chapter descries capitalstructure and e(plains its importance to solvency analysis. )ince solvency depends onsuccess in operatin% activities' the chapter e(amines earnin%s and its aility to coverimportant and necessary company e(penditures. )pecifically' this chapter descriesvarious tools of solvency analysis' includin% levera%e measures' analytical accountin%adjustments' capital structure analysis' and earnin%s!covera%e measures. Wedemonstrate these analysis tools with data from financial statements. We also discussthe relation etween ris$ and return inherent in a company#s capital structure' and itsimplications for financial statement analysis.

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&,TLI-E

)ection : Liquidity

Liquidity and Wor$in% +apital

+urrent "ssets and Liailities

Wor$in% +apital /easure of Liquidity

+urrent Ratio /easure of Liquidity

,sin% the +urrent Ratio for "nalysis

+ash!0ased Ratio /easures of Liquidity

&peratin% "ctivity "nalysis of Liquidity

"ccounts Receivale Liquidity /easures

Inventory Turnover /easures

Liquidity of +urrent Liailities

"dditional Liquidity /easures

+urrent "ssets +omposition

"cid!Test 12uic$3 Ratio

+ash 4low /easures

4inancial 4le(iility

/ana%ement#s 5iscussion and "nalysis

What!If "nalysis

)ection 6: +apital )tructure and )olvency

Importance of +apital )tructure

+haracteristics of 5et and Equity

/otivation for 5et +apital

+oncepts of 4inancial Levera%e

"djustments for +apital )tructure "nalysis

+apital )tructure +omposition and )olvency

+ommon!)i7e )tatements in )olvency "nalysis

+apital )tructure /easures for )olvency "nalysis

Interpretation of +apital )tructure /easures

"sset!0ased /easures of )olvency


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Earnin%s +overa%e

Relation of Earnin%s to 4i(ed +har%es

Times Interest Earned "nalysis

Relation of +ash 4low to 4i(ed +har%es

Earnin%s +overa%e of 8referred 5ividendsInterpretin% Earnin%s +overa%e /easures

+apital )tructure Ris$ and Return

"ppendi( ": Ratin% 5et

"ppendi( 0: 8redictin% 4inancial 5istress


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"-"L9)I) &0E+TIVE)

E(plain the importance of liquidity in analy7in% usiness activities.

5escrie wor$in% capital measures of liquidity and their components.

Interpret the current ratio and cash!ased measures of liquidity.

"naly7e operatin% cycle and turnover measures of liquidity and their interpretation.

Illustrate what!if analysis for evaluatin% chan%es in company conditions andpolicies.

5escrie capital structure and its relation to solvency.

E(plain financial levera%e and its implications for company performance andanalysis.

"naly7e adjustments to accountin% oo$ values to assess capital structure.

5escrie analysis tools for evaluatin% and interpretin% capital structurecomposition and for assessin% solvency.

"naly7e asset composition and covera%e for solvency analysis.

E(plain earnin%s!covera%e analysis and its relevance in evaluatin% solvency.

5escrie capital structure ris$ and return and its relevance to financial statementanalysis.

Interpret ratin%s of or%ani7ations# det oli%ations 1"ppendi( "3.

5escrie prediction models of financial distress 1"ppendi( 03.

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2,E)TI&-)

. Liquidity is an indicator of an entity#s aility to meet its current oli%ations. "n entityin a wea$ short!term liquidity position will have difficulty in meetin% short!termoli%ations. This has implications for any current and potential sta$eholders of a

company. 4or e(ample' lac$ of liquidity would affect users; analysis of financialstatements in the followin% ways:E!uity investor: In this case' the company li$ely is unale to avail itself of favoralediscounts and to ta$e advanta%e of profitale usiness opportunities. It could evenmean loss of control and eventual partial or total loss of capital investment."reditors: In this case' delay in collection of interest and principal due would ee(pected and there is a possiility of the partial or total loss of the amounts duethem.

6. " major limitation in usin% wor$in% capital 1in dollars3 as an analysis measure is itsfailure to meanin%fully relate it to other measure for interpretive purposes. That is'wor$in% capital is much more meanin%ful when related to other amounts' such as

current liailities or total assets. In addition' the importance attached to wor$in%capital y various users provides a stron% incentive for an entity 1especially the onesin a wea$ financial position3 to stretch the definition of its components. 4or e(ample'some mana%ers may . In classification of accounts as current or noncurrent' we loo$ to oth the intentionsof mana%ement and the normal practice for the industry 1eyond the

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B. 0an$s usually reserve the ri%ht not to renew the whole or part of a loan at their optionwhen they si%n a revolvin% loan a%reement. The fact that a an$ a%rees informally torenew short!term notes does not ma$e them noncurrent. The possiility that thecompany under analysis included such notes under lon%!term liailities should ecarefully assessed 1and potentially reclassified if our analysis su%%ests otherwise3.

C. )ome of these industry characteristics' such as the asence of any distinctionetween current and noncurrent on the alance sheet in the real estate industry' canindeed require special treatment. Dowever' even in such cases' analysts should ecareful to consider whether these special characteristics chan%e the relatione(istin% etween current oli%ations and the liquid funds availale 1or reasonalye(pected to ecome availale3 to meet them. &ur analysis should adjust theclassifications of any items not meetin% our assessment of the current andnoncurrent criteria.

F. Identical wor$in% capital does not imply identical liquidity. The asolute amount ofwor$in% capital has si%nificance only when related to other variales such as sales'total assets' etc. The asolute amount only has' at est' a limited value forintercompany comparisons. " etter %au%e of liquidity when focusin% on wor$in%

capital is to relate its amount to either or oth of current assets and current liailities1or sales' assets' etc.3.

G. The current ratio is the ratio of current assets to current liailities. It is a staticmeasure of resources availale at a %iven point in time to meet current oli%ations.The reasons for its widespread use include:

It measures the de%ree to which current assets cover current liailities.

It measures the mar%in of safety availale to allow for possile shrin$a%e in thevalue of current assets.

It measures the mar%in of safety availale to meet the uncertainties and the randomshoc$s to which the flows of funds in a company are suject.

. +ash inflows and cash outflows are not perfectly predictale. 4or e(ample' in thecase of a usiness downturn' sales can decline more rapidly than do outlays forpurchases and e(penses. The amount of cash held is in the nature of a precautionaryreserve' which is intended to ta$e care of short!term surprises in cash inflows andoutflows.

6. There is a relation etween inventories and sales. )pecifically' as sales increase1decrease3' the inventory level typically increases 1decreases3. Dowever' inventoriesare a direct function of sales only in rare cases. /ethods of inventory mana%emente(ist' and e(perience su%%ests that inventory increments vary not in proportion todemand 1sales3 ut rather with measure appro(imatin% the square root of demand.

>. /ana%ement;s major ojectives in determinin% the amounts invested in receivalesand inventories include the promotion of sales' improved profitaility' and theefficient utili7ation of assets.

?. The current ratio is a static measure. The value of the current ratio as a measure ofliquidity is limited for the followin% reasons:

4uture liquidity depends on prospective cash flows and the current ratio alone doesnot indicate what these future cash flows will e.

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There is no direct or estalished relationship etween alances of wor$in% capitalitems and the pattern which future cash flows are li$ely to assume.

/ana%erial policies directed at optimi7in% the levels of receivales and inventoriesare oriented primarily toward the efficient and profitale utili7ation of assets andonly secondarily at liquidity considerations.

@. The limitations to which the current ratio is suject should e reco%ni7ed and its useshould e restricted to the type of analytical tas$ it is capale of servin%. )pecifically'the current ratio can help assess the adequacy of current assets to dischar%e currentliailities. This implies that any e(cess 1called wor$in% capital3 is a liquid surplusavailale to meet imalances in the flow of funds' shrin$a%e in value' and othercontin%encies.

A. +ash!ased ratios of liquidity typically refer to the ratio of cash 1includin% cashequivalents3 to total current assets or to total current liailities. The choice of deflatordepends on the purposes of analysis. 1i3 The hi%her the ratio of cash to total currentassets the more liquid the current asset %roup is. This means that this portion of thetotal current assets is suject only to a minimal dan%er of loss in value in case ofliquidation and that there is practically no waitin% period for conversion of theseassets into usale cash. 1ii3 The ratio of cash to total current liailities measures howmuch cash and cash equivalents are availale to immediately pay current oli%ations.This is a severe test that i%nores the revolvin% nature of current liailities. Itsupplements the cash ratio to total current assets in that it measures cash availailityfrom a somewhat different point of view.

B. "n important measure of the quality of current assets such as receivales andinventories is their turnover. The faster the turnover*collections in case ofreceivales and sales in case of inventories*the smaller the li$elihood of loss onultimate reali7ation of these assets.

C. The avera%e accounts receivale turnover measures in effect the speed of their

collection durin% the period. The hi%her the turnover fi%ure' the faster the collectionsare' on avera%e.

F. The collection period 1or days# sales in accounts receivale3 measures the numer ofdays# sales uncollected. It can e compared to a company#s credit terms to evaluatethe quality of its collection activities.

6G. Either one or all of the followin% are possile reasons for an increase in the collectionperiod:

" relatively poorer collection jo.

5ifficulty in otainin% prompt payment for various reasons from customers in spiteof dili%ent collection efforts.

+ustomers in financial difficulty' which in turn may imply a poor jo y the creditdepartment.

+han%e of credit policies or sales terms in a desire to increase sales.

E(cessive delinquency of one or a few sustantial customers.

6. 1a3 If the inventory level is inadequate' the sales volume may decline to elow thelevel of sales otherwise attainale. " loss of potential customers can also occur. 13E(cessive inventories' however' e(pose the company to e(penses such as stora%ecosts' insurance' and ta(es as well as to ris$s of loss of value throu%h osolescence


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and physical deterioration. E(cessive inventories also tie up funds that can e usedmore profitaly elsewhere.

66. The LI4& method of inventory valuation in times of increasin% costs can render oththe inventory turnover ratio as well as the current ratio practically meanin%less.Dowever' there is information re%ardin% the LI4& reserve that is reported in financialstatements. ,se of the LI4& reserve enales the analyst to adjust an unrealisticallylow LI4& inventory value to a more meanin%ful inventory amount. )till' inintercompany comparative analysis' even if two companies use LI4& cost methodsfor their inventory valuations' the ratios ased on such inventory fi%ures may not ecomparale ecause their respective LI4& inventory pools 1ases3 may have eenacquired in years of si%nificantly different price levels.

6>. The composition of current liailities is important ecause not all current liailitiesrepresent equally ur%ent and forceful calls for payment. )ome claims' such as forta(es and wa%es' must e paid promptly re%ardless of current financial difficulties.&thers' such as trade ills and loans' usually do not represent equally ur%ent calls forpayment.

6?. +han%es in the current ratio over time do not automatically imply chan%es in liquidityor operatin% results. In a prosperous year' %rowin% liailities for ta(es can result in alowerin% of the current ratio. /oreover' in times of usiness e(pansion' wor$in%capital requirements can increase with a resultin% contraction of the current ratio*so!called prosperity squee7e. +onversely' durin% a usiness contraction' currentliailities may e paid off while there is a concurrent 1involuntary3 accumulation ofinventories and uncollected receivales causin% the ratio to rise. 4inally' advances ininventory practices 1such as just!in!time3 can lower the current ratio.

6@. Window dressin% refers to the adjustment of year!end account alances of currentassets and liailities to show a more favorale current ratio than is otherwisewarranted. This can e accomplished' for e(ample' y temporarily steppin% up the

efforts for collection' y temporarily recallin% advances and loans to officers' and yreducin% inventory to elow the normal level and use the proceeds from these stepsto pay off current liailities. The analyst should %o eyond year!end reportedamounts and try to otain as many interim readin%s of the current ratio as possile.Even if the year!end current ratio is very stron%' interim ratios may reveal that thecompany is dan%erously close to insolvency. /ore %enerally' our analysis mustalways e aware of the possiility of window dressin% of oth current and noncurrentaccounts.

6A. The rule of thum re%ardin% the current ratio is 6: * a value elow that levelsu%%ests serious liquidity ris$. "lso' the rule of thum su%%ests that the hi%her thecurrent ratio e aove the 6: level' the etter. The followin% points' however' should

e $ept in mind so as not to e(pose our analysis to undue ris$s of errors ininferences:

" current ratio much hi%her than 6 to ' while implyin% a superior covera%e ofcurrent liailities' can si%nal a wasteful accumulation of liquid resources.

It is the quality of the current assets and the nature of the current liailities that aremore si%nificant in interpretin% the current ratio*not simply the level itself.

The need of a company for wor$in% capital varies with industry conditions as wellas with the len%th of its own net trade cycle.

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6B. In an assessment of the overall liquidity of a company;s current assets' the trend ofsales is an important factor. )ince it ta$es sales to convert inventory into receivalesandHor cash' an uptrend in sales indicates that the conversion of inventories intomore liquid assets will e easier to achieve than when sales remain constant.5eclinin% sales' on the other hand' will retard the conversion of inventories into cashand' consequently' impair a company;s liquidity.

6C. In addition to the tools of analysis of short!term liquidity that lend themselves toquantification' there are important qualitative considerations that ear on short!termliquidity. These can e usefully characteri7ed as dependin% on the financial fle(iilityof a company. 4inancial fle(iility is the aility of a company to ta$e steps to counterune(pected interruptions in the flow of funds. This refers to the aility to orrow froma variety of sources' to raise equity capital' to sell and redeploy assets' and to adjustthe level and direction of operations to meet chan%in% circumstances. The capacityto orrow depends on numerous factors and is suject to rapid chan%e. It dependson profitaility' staility' relative si7e' industry position' asset composition and capitalstructure. It will depend' moreover' on such e(ternal factors as credit mar$etconditions and trends. The capacity to orrow is important as a source of funds in atime of need and is also important when a company must roll over its short!term det.

8rearran%ed financin% or open lines of credit are more reliale sources of funds intime of need than is potential financin%. &ther factors which ear on the assessmentof the financial fle(iility of a company are the ratin%s of its commercial paper' ondsand preferred stoc$' restrictions on the sale of its assets' the de%ree of discretionwith its e(penses as well as the aility to respond quic$ly to chan%in% conditionssuch as stri$es' shrin$in% demand' and cessation of supply sources.

The )E+ requires a /ana%ement#s 5iscussion and "nalysis of 4inancial +onditionand Results of &perations 1/5"3. This requirement includes a discussion ofliquidity factors*includin% $nown trends' demands' commitments or uncertaintiesli$ely to have a material impact on the company#s aility to %enerate adequateamounts of cash. If a material deficiency in liquidity is identified' mana%ement must

discuss the course of action it has ta$en or proposes to ta$e to remedy thedeficiency. In addition' internal and e(ternal sources of liquidity as well as anymaterial unused sources of liquid assets must e identified and descried.

6F. The importance of projectin% the effects of chan%es in conditions and policies on thecash resources of a company is to allow for proper plannin% and control. 4ore(ample' if mana%ement decides to ease the credit terms to its customers' $nowin%the impact of the new policy on cash resources will help it ma$e a more informeddecision. It may see$ improved terms from suppliers or ma$e arran%ements to otaina loan.

>G. Jey elements in evaluatin% lon%!term solvency are:

"nalysis of the capital structure of the firm. "ssessin% different ris$s for different types of assets.

/easurin% earnin%s' earnin% power' and earnin%s trend.

Estimatin% earnin%s covera%e of fi(ed char%es.

"ssessin% the asset covera%e of loans.

/easurin% protection afforded y loan covenants and collateral a%reements.

>. "nalysis of capital structure is important ecause the financial staility of a companyand the ris$ of insolvency depend on the financin% sources as well as on the type of

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assets it holds and the relative ma%nitude of such asset cate%ories. )pecifically' thereare essential differences etween det and equity' which are the two major sources offunds. Equity capital has no %uaranteed return that must e paid out and there is notimetale for repayment of the capital investment. 4rom the viewpoint of a company'equity capital is permanent and can e counted on to remain invested even in timesof adversity. Therefore' the company can confidently invest equity funds in lon%!termassets and e(pose them to the %reatest ris$s. &n the other hand' dets are e(pectedto e paid at certain specified times re%ardless of a company#s financial condition. Tothe investor in common stoc$' the e(istence of det contains a ris$ of loss ofinvestment. The creditors would want as lar%e a capital ase as is possile as acushion that will shield them a%ainst losses that can result from adversity. Therefore'it is important for the financial analyst to review carefully all the elements of thecapital structure.

>6. 4inancial levera%e is the result of orrowin% and incurrin% fi(ed oli%ations forinterest and principal payments. The owners of a successful usiness that requiresfunds may not want to dilute their ownership of the usiness y issuin% additionalequity. Instead' they can trade on the equity y orrowin% the funds required' usin%their equity capital as a orrowin% ase. 4inancial levera%e is advanta%eous when the

rate of return on total assets e(ceeds the net after!ta( interest cost paid on det. "nadditional advanta%e provided y financial levera%e is that interest e(pense is ta(deductile while dividend payments are not.

>>. Levera%e is a two!ed%ed sword. In %ood times' net income enefit from levera%e. In arecession or when une(pected adverse events occur' net income can e harmed ylevera%e. Therefore' the use of levera%e is acceptale to the financial mar$ets only upto some undefined level. -inety percent is hi%her than that ?. In an analysis of deferred income ta(es' the analyst must reco%ni7e that under normalcircumstances the deferred ta( liailities will

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%enerally e considered the equivalent of det financin%. 1)ee +hapter > foradditional analysis and discussion.3

>A. &ff!alance!sheet financin% are attempts y mana%ement to structure transactions insuch a way as to e(clude det 1and related assets3 from the alance sheet. This isusually accomplished y emphasi7in% le%al 1accountin%3 form over sustance.E(amples of such transactions are ta$e or pay contracts' certain sales of receivales'and inventory repurchase a%reements.

>B. 8ension accountin% reco%ni7es that if the fair value of pension assets falls short ofthe accumulated pension enefit oli%ation' a liaility for pensions e(ists. Dowever'this liaility normally does not ta$e into consideration the projected enefit oli%ationthat reco%ni7es an estimate for future pay increases. When pension plans ase theirenefits on future pay formulas' the analysts' who jud%e such understatement asserious and who can estimate it' may want to adjust the pension liaility for analysispurposes.

>C. The preferred method of presentin% the financial statements of a parent and itssusidiary is in consolidated format. This is also the preferred method from an

analysis point of view. Dowever' separate financial statements of the consolidatedentities are necessary in some cases' such as when the utili7ation of assets of asusidiary 1such as an insurance company or a an$3 is not suject to the fulldiscretion of the parent. Information on unconsolidated susidiaries is also importantwhen ondholders of such susidiaries must loo$ only to a susidiary;s assets assecurity. /oreover' ondholders of the parent company 1particularly holdin%companies3 may derive a si%nificant portion of their fi(ed char%e covera%e from thedividends of the unconsolidated susidiaries. 9et' in the event of the susidiary#san$ruptcy' the parent ondholders may e in a junior position to the ondholders ofthe susidiary.

>F. a. Kenerally' the minority interest is shown amon% liailities in consolidated financial

statements. Dowever' the minority interest differs from det in that it has neithermandatory dividend payment requirements nor principal repayment requirements.Therefore' for the purpose of capital structure analysis' it may e classified asequity rather than as a liaility.

. The purpose of appropriatin% retained earnin%s is to set aside a certain portionof retained earnin%s to prevent them from servin% as a asis for the declaration ofdividends. There e(ists no claim y an outsider to such an appropriation until thecontin%ency materiali7es. Therefore' unless the reason for the amount reserved iscertain to occur' such appropriations should e considered a part of equitycapital.

c. " %uarantee for product performance is the result of a definite contract with theuyer that commits the entity to correct product defects. Therefore' it is a

potential liaility and should e classified as such.d. +onvertile det is %enerally classified amon% liailities. Dowever' if the terms ofconversion and the mar$et price of the common stoc$ are such that it is mostli$ely to e converted into common stoc$' it should e considered as equity forthe purpose of capital structure analysis.

e. /ost preferred stoc$ entails no asolute oli%ation for payment of dividends orrepayment of principal*that is' it possesses characteristics of equity. Dowever'preferred stoc$ with a fi(ed maturity or suject to sin$in% fund requirementsshould' from an analysis point of view' e considered as det.


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?G. a. The equity of a company is measured y the e(cess of total assets over totalliailities. "ccordin%ly' any analytical revision of asset oo$ values 1from amountsreported at in the financial statements3 yields a chan%e in the amount of equity.4or this reason' in assessin% capital structure' the analyst must decide whether ornot the oo$ value amounts of assets are realistically stated in li%ht of analysisojectives.

. The followin% are e(amples of the need for possile adjustments. 5ifferent oradditional adjustments may e needed dependin% on circumstances: 13Inventories carried at LI4& are %enerally understated in times of risin% prices. Theamount y which inventories computed under 4I4& 1which are closer toreplacement cost3 e(ceed inventories computed under LI4& is disclosed as theLI4& reserve. These disclosures should enale the analyst to adjust inventoryamounts and the correspondin% equity amounts to more realistic current costs.163 4or fiscal years e%innin% efore 6HAHF>' mar$etale securities were%enerally stated at cost' which may e elow mar$et value. ,sin% parenthetical orfootnote information' the analyst can ma$e an analytical adjustment increasin%this asset to mar$et value and increasin% owner#s equity y an equal amount. 1>3

Intan%ile assets and deferred items of duious value' which are included on theasset side of the alance sheet' have an effect on the computation of the totalequity of a company. To the e(tent that the analyst cannot evaluate or form anopinion on the present value or future utility of such assets' they may e e(cludedfrom consideration' therey reducin% the amount of equity y the amounts atwhich such assets are carried. Dowever' the aritrary e(clusion of all intan%ileassets from the capital ase is an unjustified e(ercise in over!conservatism.

?. Lon%!term creditors are interested in the future operations and cash flows of a detor1in addition to the short!term financial condition of the detor3. 4or e(ample' acreditor of a three!year loan would want to ma$e an analysis of solvency assumin%the worst set of economic and operatin% conditions. 4or such purposes' an analysis

of short!term liquidity is usually not adequate. Dowever' such a dynamic analysis forthe lon% term is suject to sustantial uncertainties and requires assumptions for amuch lon%er time hori7on. The inevitale lac$ of detail and the uncertainties inherentin lon%!term projections severely limit their reliaility. This does not mean thatlon%!term projections are not useful. What it does mean is that the analyst must eaware of the serious limitations to which they are suject.

?6. +ommon!si7e analysis focuses on the composition of the funds that finance acompany. "s such' it reflects on the financial ris$ inherent in the capital structure.)pecifically' it shows the relative ma%nitudes of the financin% sources of the companyand allows the analyst to compare them with similar data of other companies. Instead'capital structure ratios reflect on the financial ris$ of a company y relatin% various

components of the capital structure to each other or to total financin%. "n advanta%eof ratio analysis is that it can e used as a screenin% device and' moreover' canreflect on relations across more than one financial statement.

?>. The difference etween the oo$ value of equity capital and its mar$et value isusually due to a numer of factors. &ne of these is the effect of price!level chan%es.These' in turn' are caused y at least two factors: chan%e in the purchasin% power ofmoney and chan%e in price due to economic factors such as the law of supply anddemand. Therefore' with fluctuatin% prices' it is unli$ely that historical cost will


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correspond to mar$et value. "ccountin% methods in use can also si%nificantly affectthe oo$ values of assets. 4or e(ample' a particular depreciation method often isadopted for ta( reasons rather than to measure the loss of value of an asset due touse or osolescence. The analyst could potentially adjust for this distortion of currentvalue y valuin% the equity at mar$et value. 4or actively traded securities this wouldnot e too difficult. Dowever' the stoc$ mar$et too is often suject to sustantialovervaluation and undervaluation dependin% on the de%ree of speculative sentiment.Dence' in most cases' equity capital will not e adjusted to mar$et*instead' thefocus will e on valuin% assets and liailities' with equity as a residual value.

??. )ince liailities and equity reveal the financin% sources of a company' and the assetside reveals the investment of these funds' we can %enerally estalish direct relationsetween asset %roups and selected items of capital structure. This does not' ofcourse' imply that resources provided y certain liailities or equity should e directlyassociated with the acquisition of certain assets. )till' it is valid to assume that thetypes of assets a company employs should determine to some e(tent the sources ofresources used to finance them. Therefore' to help assess the ris$ e(posure of a%iven capital structure' the analysis of asset distriution is one important dimension."s an e(ample' if a company acquired lon%!term assets y means of short!term

orrowin%s' the analyst would conclude that this particular method of financin%involves a considerale de%ree of ris$ 1and cost3.

?@. The earnin%s to fi(ed char%es ratio measures directly the relation etweendet!related and other fi(ed char%es and the earnin%s availale to meet thesechar%es. It is an evaluation of the aility of a company to meet its fi(ed char%es out ofcurrent earnin%s. Earnin%s covera%e ratios are superior to other tools' such as det!to!equity ratios' which do not focus on the availaility of funds. This is ecauseearnin%s covera%e ratios directly measure the availaility of funds for payment offi(ed char%es. 4i(ed char%es are mainly a direct result of the incurrence of det. "ninaility to pay their associated principal and interest payments represents the mostserious ris$ consequence of det.

?A. Identifyin% the items to include in fi(ed char%es depends on the purpose of theanalysis. 4i(ed char%es can e defined narrowly to include only interest and interestequivalents or roadly to include all outlays required under contractual oli%ations*specifically:1a3 Interest and interest equivalents:

i. Interest on lon%!term det 1includin% amorti7ation of any discounts andpremiums3.

ii. Interest element included in lon%!term lease rentals.iii. +apitali7ed interest.

13 &ther outlays under contractual oli%ations:i. Interest on income onds 1assumin% profitale operations*implicit

assumption in such orrowin%s3.ii. Required deposits to sin$in% funds and principal payments under serial ondoli%ations.

iii. 8rincipal repayments included in lease oli%ations.iv. 8urchase commitments under noncancelale contracts to the e(tent that

requirements e(ceed normal usa%e.v. 8referred stoc$ dividend requirements of majority!owned susidiaries.vi. Interest on recorded pension liailities.


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vii. Kuarantees to pay fi(ed char%es of unconsolidated susidiaries if therequirement to honor the %uarantee appears imminent.

1c3 &ther fi(ed char%es*such as imputed interest in the case on non!interest or lowinterest!earin% oli%ations. These are not periodical fund drains.

4or each of the aove cate%ories' the correspondin% income to e included in theratio computation should e adjusted accordin%ly. Re%ardin% fi(ed char%es' thoseitems not ta( deductile must e ta( adjusted. This is done y increasin% them y anamount equal to the income ta( that would e required to otain an after!ta( incomesufficient to cover the fi(ed char%es. The ta( rate to e used should e ased on therelation of the ta(es on income from continuin% operations to the amount of pre!ta(income from continuin% operations*the company#s effective ta( rate.

?B. " company normally si%ns a lon%!term purchase contract to either insure that itssupply of essential raw material is not interrupted or to %et a favorale purchasediscount' or oth. In times of favorale economic conditions' the analyst need notworry aout most such commitments 1indeed' they are a positive factor3. The onlye(ception is when such commitments reflect amounts in e(cess of requirements%iven e(pected sales. "ccordin%ly' if the analyst concludes that the purchase

commitments represent the minimum required supplies' sHhe can justifialy e(cludethe commitments from fi(ed char%es. If the analyst includes the commitments in fi(edchar%es' income should e adjusted to reflect the ta(!deductile nature of thepurchase that will eventually e recorded as cost of %oods sold. 8roceeds from theforced sale of e(cess supplies can also e deducted on an estimated asis.

?C. -et income includes items of revenue that do not %enerate immediate cash. It alsoincludes e(penses that do not require the immediate use of cash. 4or a measure ofcash availale to meet fi(ed char%es' the more relevant fi%ure is cash provided yoperations reported in the statement of cash flows. -et income can sometimes eused as a pro(y of this more appropriate measure of cash availaility.

?F. )ince +ompany 0 is under the control of +ompany "' the latter can siphon off fundsfrom it to the detriment of 0#s creditors. /oreover' the customer!supplier relationshipwith +ompany " means that +ompany " has considerale discretion in the allocationof revenues' costs' and e(penses amon% the two entities in such a way as todetermine which company will show what portion of the total availale income. Thisa%ain can wor$ to the detriment of +ompany 0#s creditors. "s a lender to +ompany 0'one would want to write into the lendin% a%reement conditions that would preventparent +ompany " from e(ercisin% its controllin% powers to the detriment of thelender.

@G. 5et can never e e(pected to carry the ris$s and returns of ownership ecause ofthe fi(ed nature of its rewards. "lso' it cannot serve as the permanent ris$ capital of a

company ecause it must e repaid with interest. /oreover' det is incurred on thefoundation of an equity ase. Indeed' equity financin% shields or at least reduces theris$s of det financin%. Equity financin% also asors the losses to which a companyis e(posed. +onsequently' the assertion is asically accurate.

@. The advanta%es of convertile det are that the company is ale to potentiallyenlar%e its equity ase 1andHor at a potentially lower cost3 than it mi%ht otherwise eale to with pure equity financin%. "lso' it mi%ht e ale to sell equity shares at aprice in e(cess of the current mar$et price and to otain' in the interim' a lower


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interest cost ecause of the conversion feature of the det. The disadvanta%es arethat a susequent decline in the mar$et price of the stoc$ can postpone conversionsustantially and indefinitely. This would leave the company with a det urden that itwas not prepared to shoulder over the lon% term. +onsequently' what may have eenconceived of as temporary financin% can' in fact' ecome lon%!term det financin%.

@6. 1a3 Lon%!term indentures span such an e(tended period of time that they are sujectto many uncertainties and imponderales. +onsequently' lon%!term creditorsoften insist on the maintenance of certain ratios at specified levels andHor controlsover specific mana%erial actions and policies 1such as dividends and capitale(penditures3. Dowever' no restrictive covenant or other contractual arran%ementcan prevent operatin% losses' which present the most serious ris$ to lon%!termcreditors.

13 . /aintenance of a minimum de%ree of short!term liquidity.6. 8revention of the dissipation of equity capital y retirement' refundin%' or the

payment of e(cessive dividends.>. 8reservation of equity capital for the safety of creditors.?. Insure the aility of creditors to protect their interests in a deterioratin%

situation.

@>. The major reason why det securities are rated while equity securities are not restin the fact that there is a far %reater uniformity of approach and homo%eneity ofanalytical measures used in the evaluation of credit worthiness than there is in theevaluation of equity securities. This increased a%reement on what is ein%measured in credit ris$ analysis has resulted in widespread acceptance of andreliance on pulished credit ratin%s in many sectors of the analyst community.

@?. In ratin% an industrial ond issue' ratin% a%encies focus on the issuin% company#sasset protection' financial resources' earnin% power' mana%ement' and the specificprovisions of the det security. "sset protection is concerned with measurin% the

de%ree to which a company#s asset protection' financial resources' earnin% power'mana%ement' and the specific provisions of the det security. 4inancial resourcesencompass' in particular' such liquid resources as cash and other wor$in% capitalitems. 4uture earnin% power is a factor of %reat importance in the ratin% of detsecurities ecause the level and the quality of future earnin%s determine importantlya company#s aility to meet its oli%ations. Earnin%s power is %enerally a morereliale source of security than is asset protection. /ana%ement ailities' philosophy'depth' and e(perience always loom importantly in any final ratin% jud%ment. Throu%hinterviews' field trips and other analyses the raters proe into mana%ement#s %oals'the plannin% process as well as strate%ies in such areas as research anddevelopment' promotion' new product plannin% and acquisitions. The specificprovisions of the det security are usually spelled out in the ond indenture.

@@. The analyst who can effectively e(ecute financial statement analysis can alsoimprove on the pulished ond ratin%s. Indeed' effective financial statement analysisis possily even more valuale in the valuation of det securities than in the case ofequity securities. 0ond ratin%s cover a wide ran%e of characteristics and they presentopportunities for those who can etter identify $ey differences within a ratin%classification. /oreover' ratin% chan%es %enerally la% the mar$et. This la% presentsadditional opportunities to an analyst who with superior s$ill and alertness canidentify important chan%es efore they ecome %enerally reco%ni7ed.

Financial Statement Analysis, 8th Edition11-1#

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@A. +ompanies hire ond!ratin% a%encies to rate their det ecause these ratin%s arean e(ternally %enerated' independent si%nal of the company#s creditworthiness andquality. Investors would rely less on ratin%s if they were produced in!house ecauseof mana%ement#s incentives to report hi%h quality and of mana%ement self!interest. Inshort' they act as independent si%nals of det quality.

Instructor's Solutions Manual 11-1$

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EER+I)E)

E(ercise ! 16G minutes3

"urrent atio (uic) atio *or)in+ "aital

.M -o chan%e -o chan%e -o chan%e6. -o chan%e -o chan%e -o chan%e>. Increase Increase Increase?. 5ecrease -o chan%e 5ecrease@. 5ecrease 5ecrease 5ecreaseA. 5ecrease 5ecrease 5ecreaseB. Increase Increase -o chan%eC. 5ecrease 5ecrease -o chan%eF. Increase Increase IncreaseG. -o chan%e 5ecrease -o chan%e

M "ssumes a sufficient amount is provided for in the "llowance for 0ad 5ets.

E(ercise !6 1>G minutes3a. /. c. 0ournal Entry Elanation

. -E -E 5 +&K) @GG +ost of %oods sold increases y @GGN R.E. @GG avera%e inventory increases y 6@GN ratio

1c3 decreases.6. I 5 -E "ccts Recle 5enominator will increase y half the

)ales amount of the numerator causin% the 1a3ratio to increase. 5enominator of ratio 13will increase causin% the ratio to decrease.There is no effect on the components ofratio 1c3.

>. I 5 -E "llow for 0ad 5ets The numerator in ratio 1a3 won#t chan%e"ccts Recle and the denominator will decrease thus

increasin% the ratio. 0ecause ratio 1a3 willincrease' ratio 13 will decrease as theavera%e accounts receivale turnoverincreases. Ratio 1c3 is unaffected.

?. I 5 -E 0ad 5et E(pense Ratio 1a3 will increase due to the"ccts Recle decrease in the denominator. Ratio 13 will

decrease due to the increase in thedenominator' which is due to the increasein ratio 1a3. Ratio 1c3 is unaffected.

@. -E -E I +&K) &nly ratio 1c3 is affected. The numerator

Inventory increases while the denominatordecreases.

A. -E -E I R.E. @GG -either ratio 1a3 nor 13 are affected. The+&K) @GG avera%e inventory will decrease y @GO of

the decrease in the numerator in ratio 1c3due to the avera%in% effect' thusincreasin% the ratio.

E(ercise !> 1>G minutes3


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a. /. c. 0ournal Entry Elanation

. -E -E -E "llow for 0ad 5ets )ince we use the net ".R. in"ccts Recle computation of ratio' there is no effect.

6. -E -E 5 +&K) -either ratio 1a3 nor 13 is affected. TheR.E. cost of %oods sold increases y P'GGG'

and avera%e inventory will increase yP@GG 1due to the avera%in% effect3' thusdecreasin% ratio 1c3.

>. -E -E I +&K) &nly ratio 1c3 is affected. TheInventory numerator increases while the

denominator decreases.

?. -E -E I Loss -either ratio 1a3 nor 13 is affected.Inventory "vera%e inventory will decrease y

P'@GG 1half of P>'GGG3' increasin% ratio 1c3.

@. -E -E I R.E. -either ratio 1a3 nor 13 is affected. The+&K) avera%e inventory will decrease y half

of the decrease in the numerator.

A. I 5 -E )ales 5enominator of ratio 1a3 decreases y"ccts Recle half the amount the numerator decreases'

causin% ratio 1a3 to increase. 5enominatorof ratio 13 will increase' causin% it todecrease. There is no effect on ratio 1c3.

E(ercise !? 1?@ minutes3a. /ethods to window dress financial statements to improve the current and quic$

ratios:. 8ay off accounts payale with cash. This would have the effect of reducin%

oth current assets and current liailities y the same amount' thus increasin%the current ratio and quic$ ratio.

6.M Invest additional capital funds at year!end. This would increase cash withoutaffectin% current liailities.

>.M )ell fi(ed assets for cash or short!term notes. This would increase currentassets' ut decrease only fi(ed assets. Thus' the current and quic$ ratioswould improve.

?.M 0orrow cash y incurrin% lon%!term liailities 1notes or onds3. This wouldincrease cash' ut would not affect current liailities' since the purpose is toma$e them lon%!term liailities.

@.M 5efer incurrin% various e(penses' such as advertisin%' research anddevelopment' and mar$etin%' alon% with reducin% capital e(penditures.

A. Jeep the cash receipts oo$s open lon%er' in an effort to show hi%herreceivales or collections. This method is a hi%hly irre%ular and manipulativedevice.

M These procedures are normal usiness transactions that cannot usually e consideredmanipulative in character. They may ecome manipulative when they have no soundusiness justification and are underta$en solely to influence the measures used youtside analysts.

Instructor's Solutions Manual 11-1%

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. The analyst could' if all underlyin% evidence and documents were availale'detect each of these methods. Dowever' sufficient evidence' such as invoices andthe oo$s of ori%inal entry' will most li$ely not e availale for inspection./oreover' these methods may not e reco%ni7ale throu%h the usual analysis offinancial statements of the company. If sufficient evidence were availale' thefollowin% are techniques that may e used to detect the methods descried in a.

. The analyst could determine the company#s usual payment policies' andcompare them with those employed at year!end. )Hhe could loo$ at the termsof the liailities' to see if they were paid at the most eneficial time*in otherwords' if any economic enefit was derived y payin% them earlier than due orwhen normally paid. )Hhe could inspect the payments in the first month of thefollowin% year' to see if liailities were paid disproportionately to year!end'ta$in% into account due dates and normal requirements. "n unusually lowinventory at year!end mi%ht also indicate failure to purchase merchandise atyear!end in an effort to improve the quic$ ratio.

6. The analyst could analy7e the timin% of investments and the use to which theywere put. If sHhe sees lar%e capital infusions at year!end' and that theseinvestments were represented y idle cash' or y mar$etale securities which

are not related to operations' and where there is little proaility of such fundsein% required for operations in the near future' the reason mi%ht e windowdressin%.

>. +ontracts and invoices mi%ht e e(amined to see when they were entered intoand when they were recorded.

?. The procedures for investi%ation of e(cessive orrowin% at year!end are thesame as those for e(cessive investments of equity funds 16. aove3. "lso' thecontracts should e studied to determine if they are ona fide loans.

@. The purchase journal and cash disursements journal should e e(amined tocompare e(penses incurred towards the end of the year with e(penses at thee%innin% of the followin% year' and the reasons for lar%e differences.

A. To determine if the oo$s are ein% $ept open too lon%' the analyst would

study such documents as the underlyin% invoices and canceled chec$s todetermine their actual dates' and to compare this with the dates recorded. )Hhemi%ht also confirm material accounts with customers as of the year!end.


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E(ercise !@ 1>G minutes3

A "

. -E -E IHIQ5 IHIQ56. 5H-EQ5 5H-EQ5 5H5QI 5H5QI>. IH-EQI IH-EQI IHIQ5 IHIQ5

?. -EHIQ5 -EHIQ5 IHIQ5 IHIQ5@. -E -E 5H-EQ5 -EA. -E -E -E IH-EQIB. -E -E IHIQ5 IHIQ5C. -E -E 5H5QI 5H5QIF. 5HIQ5 5HIQ5 -E -EG. IH-EQI -E -E -E

M Ratio codes and definitions:". Total det H Total equity0. Lon%!term det H Total equity+. 8re!ta( earnin%s S 4i(ed char%es 14+3 H 4+5. 8reta( +4& S 4+ H 4+

E(ercise !A 16@ minutes3I. II. aIII. IV. V. d


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8R&0LE/)

8rolem ! 1AG minutes3

a. )hort!term liquidity ratios for +ampell )oup:

. >A H ?@ Q P'AA@.@ H P'6FC. Q .6C

6. 1PCG.B > S P66.@ >6 S PA6?.@ >>3 H P'6FC. ?@ Q G.@A

>. PA'[email protected] > H 1PA6?.@ >> S P@A?.3H6 Q G.??

?. P?'[email protected] ? H 1PCF.C >? S PCA.G3H6 Q @.6

@. PA6?.@ >> H 1PA'[email protected] H >AG3 Q >A.6>

A. PCF.C H 1P?'[email protected] H >AG3 Q AF.>

B. >A.6> S AF.> Q G@.@?

C. 1PCG.B S P66.@3 H P'AA@.@ Q G.GA6

F. 1PCG.B S P66.@3 H P'6FC. Q G.GBF@G.

Endin% inventoryUUUUUUUU P CF.C >?S+ost of %oods soldUUUUUUU. ?'[email protected] ?! 0e%innin% inventory.UUUUUU. CA.G 1%iven3! 5epreciationUUUUUUUUUU. C?. CBQ8urchases.UUUUUUUUUUU P?'GBB.F

1P@[email protected] ? H 1P?'GBB.F H >AG3 Q ?A.>A

. G@.@? ! ?A.>A Q @F.C

6. P??C.? A? H P'6FC. ?@ Q >?.@?O. +ampell;s liquidity position is e(cellent for a couple of reasons. 4irst' the

company has adequate current assets relative to current liailities asevidenced y its current and acid!test ratios. )econd' the company earnsconsistent sales and collects on receivales as evidenced y its receivalesturnover. +onsequently' the company %enerates aundant cash to supplementits current assets.

c. +urrent assets usin% 4I4& Q P'AA@.@ >A S PC?.A @> Q P'B@G.

+&K) 14I4&3 Q +&K) 1LI4&3 S LI4& reserveQ P?'[email protected] S PC?.A ! 1PFG? ! PCA3 Q P?'6@?.C

. P'B@G. H P'6FC. Q .>@?. P?'6@?.C H 1PFG?.? S PFG?3H6 Q ?.B

@. PA6?.@ >> H 1PA'[email protected] > H >AG3 Q >A.6>

A. PFG?.? H 1P?'[email protected] H >AG3 Q BA.?A

B. >A.6> S BA.?A Q 6.AFd. 5isre%ardin%' for purposes of this analysis' the prepaid e(penses and similar

unsustantial items enterin% the computation of the current ratio' we are left with


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the four major elements that comprise this ratio*those are cash' accountsreceivale' inventories' and current liailities. If we define liquidity as the aility toalance required cash outflows with adequate inflows' includin% an allowance forune(pected interruptions of inflows or increases in outflows' we must as$: 5oesthe relation of these four elements at a %iven point in time:. /easure and predict the pattern of future fund flows

6. /easure the adequacy of future fund inflows in relation to outflows,nfortunately' the answer to oth of these questions is primarily no. The currentratio is a static concept of what resources are availale at a %iven moment in timeto meet the oli%ations at that moment. The e(istin% reservoir of net funds doesnot have a lo%ical or causal relation to the future funds that will flow throu%h it.

9et it is the future flows that are the suject of our %reatest interest in theassessment of liquidity. These flows depend importantly on elements notincluded in the ratio itself' such as sales' profits' and chan%es in usinessconditions. There are at least three conclusions that can e drawn:. Liquidity depends to some e(tent on cash or cash equivalents alances' ut to

a much more si%nificant e(tent on prospective cash flows.6. There is no direct or estalished relation etween alances of wor$in% capital

items and the pattern that future cash flows are li$ely to assume.>. /ana%erial policies directed at optimi7in% the levels of receivales andinventories are mainly directed towards efficient and profitale assetutili7ation and only secondarily towards liquidity.

These conclusions oviously limit the value of the current ratio as an inde( ofliquidity. /oreover' %iven the static nature of this ratio and the fact that it consistsof items that affect liquidity in different ways' we must e(ercise caution in usin%this ratio as a measure of liquidity.

e. "ccounts receivale turnover rates or collection periods can e compared toindustry avera%es or to the credit terms %ranted y the company. When thecollection period is compared with the terms of sale allowed y the company' the

de%ree to which customers are payin% on time can e assessed. In assessin% thequality of receivales' the analyst should rememer that a si%nificant conversionof receivales into cash' e(cept for their use as collateral for orrowin%' cannote achieved without a cutac$ in sales volume. The sales policy aspect of thecollection period evaluation must also e $ept in mind. " company may e willin%to accept slow!payin% customers who provide usiness that is' on an overallasis' profitaleN that is' the profit on sale compensates for the e(tra use y thecustomer of the company funds. This circumstance may modify the analyst#sconclusions re%ardin% the !ualityof the receivales ut not those re%ardin% theirli!uidity.The current ratio computation views its current asset components as sources offunds that can' as a means of last resort' e used to pay off the current liailities.Viewed this way' the inventory turnover ratios %ive us a measure of the quality aswell as of the liquidity the inventory component of the current assets. The qualityof inventory is a measure of the company#s aility to use it and dispose of itwithout loss. When this is envisa%ed under conditions of forced liquidation' thenrecovery of cost is the ojective. In the normal course of usiness' the inventoryshould' of course' e sold at a profit. Viewed from this point of view' the normalprofit mar%in reali7ed y the company assumes importance ecause the fundsthat will e otained' and that would theoretically e availale for payment ofcurrent liailities' will include the profit in addition to the recovery of cost. In othcases' costs of sales will reduce net proceeds. In practice' a %oin% concern


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cannot use its investment in inventory for the payment of current liailitiesecause any drastic reduction in normal inventory levels will surely cut into thesales volume. The turnover ratio is a %au%e of liquidity in that it conveys ameasure of the speed with which inventory can e converted into cash. In thisconnection' a useful additional measure is the conversion period of inventories.


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8rolem !6 1?@ minutes34uture Technolo%ies' Inc.

+ash 4orecast4or 9ear Ended 5ecemer >' 9ear 6

+ash' anuary ' 9ear 6 P ?6'GGG

+ash +ollections:"ccounts receivale' an. '9ear 6 P FG'GGG)alesM ?B6'@GG

@A6'@GGLess discount on sales a 1F?@3Less acct. rec.' 5ec. >' 9ear 6 1B6'CC3 ?CF'>ABTotal cash availale P @>'>AB

+ash 5isursements:"ccounts payale' an .' 9ear 6 P BC'GGG8urchases c >@A'BAGLess: "cct. pay.' 5ec. >' 9ear 6 d 1>6'@3 >G6'6?F

"ccrued ta(es paid G'CGG&ther e(penses*+ash e A'@@G ?6F'@FF+ash availale' 5ec. >' 9ear 6 P G'BAC

+ash needed for equipment 1B@'GGG3+ash alance desired 1>G'GGG35eficiency in +ash 1need to orrow3 P1G>'6>63

M )ales: P?@G'GGG ( .G@ Q P?B6'@GG+ost of %oods sold P>6'GGG ( .FC Q P>G@'BAG

a P?B6'@GG ( GO ( 6O Q PF?@ 1discount on sales3 P?B6'@GG ( FGO ( 1AGH>AG3 Q PBG'CB@

P?B6'@GG ( GO ( 1GH>AG3 Q '>> PB6'CC 1"ccounts receivale' 5ec. >' 9ear 63c

9ear 6 +ost of %oods sold..UUUU... P>G@'BAGEndin% inventoryUUUUUUUUU.. FG'GGG 1%iven3Koods availale for sale.UUUUU... P>F@'BAG0e%innin% inventoryUUUUUUUU >F'GGG8urchasesUUUUUUUUUUUU.. P>@A'BAG

d "ccounts 8ay.' 6H>H9ear 6 Q 9r 6 8urchases ( 1".8.' 6H>H9ear H 9r 8urchases3"ccounts 8ay.' 6H>H9ear 6 Q P>@A'BAG ( 1PBC'GGG H P6G'GGG3 Q P>6'@

e 9ear :)alesUUUUUUUUUUUUU

P ?@G'GGG

+ost of %oods soldUUUUUU. 1>6'GGG35epreciationUUUUUUUUU..

1@'GGG3

-etincomeUUUUUUUUUU.

16'GGG3

&there(pensesUUUUUUUU

P 'GGG

&ther e(penses 19ear 63 Q P'GGG ( .G@ Q PA'@@G


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8rolem !> 1?@ minutes3

R"/ +orporation+ash 4orecast efore 8olicy +han%es4or 9ear Ended 5ecemer >' 9ear 6

+ash' anuary ' 9ear 6UUUUUUUU P CG'GGG

+ash +ollections:"ccounts receivale' an. UUUU P@G'GGG)ales 1CGG'GGG ( GO3UUUUUU. CCG'GGGLess: "ccounts recle.' 5ec. > a.. 1A@'GGG3 CA@'GGG

Total cash availale UUUUUUUUU.. F?@'GGG

+ash 5isursements:"ccounts payale' an. UUUUU. P>G'GGG8urchases UUUUUUUUUU.. A@B'GGGLess: "ccounts pay.' 5ec. > cU... 16??'GGG3 @?>'GGG

Increase in notes payaleUUUU... 1@'GGG3"ccrued ta(esUUUUUUUUUU. 6G'GGG+ash e(penses dUUUUUUUU. 6@C'@GG

CGA'@GG-et cash flowUUUUUUUUUUUU... P>C'@GG

+ash alance desiredUUUUUUUUU @G'GGG+ash e(cessUUUUUUUUUUUUU. P CC'@GG

-otes:a >AG days H 1PCGG'GGGHP@G'GGG3 Q AB.@ days

"pplied to 9ear 6 sales: PCCG'GGG ( 1AB.@H>AG3 Q PA@'GGG

9ear 6 +ost of sales 1P@6G'GGG ( GO3UUUUUU P@B6'GGGEndin% inventory 1%iven3UUUUUUUUUUU @G'GGGKoods availale for saleUUUUUUUUUUU B66'GGG0e%innin% inventoryUUUUUUUUUUUUU A@'GGG8urchasesUUUUUUUUUUUUUUUUU.. PA@B'GGG

c 8urchases ( 19ear "ccounts payale H 9ear 8urchases3Q PA@B'GGG ( 1P>G'GGG H P>@G'GGG3 Q P6??'GGG

d Kross profit 1PCCG'GGG ! P@B6'GGG3UUUUUUUU P>GC'GGGLess: -I 1GO of P6G'GGG 9ear -I3 S 1GO of 9ear depreciationM3 1P66'GGG S P6'@GG3U P6?'@GG

5epreciation noncashUUUUUUUUUUUU.. 6@'GGG ?F'@GG&ther cash e(penses P6@C'@GGM 5epreciation e(pense is not e(pected to increase y GO.


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a. What!If "nalysis of 8roposed +redit 8olicy +han%e:".R.' 5ec. > PCCG'GGG 1sales3 ( 1FGH>AG3UU.

P 66G'GGG

Less ".R. from forecast statement1aove3.....

A@'GGG

"dditional cash neededUUUUUUUUUU @@'GGG

+ash e(cess 1aove3UUUUUUUU...UU.. CC'@GG+ash e(cess for this proposalUUUUUUU P >>'@GG

. What!If "nalysis of 8roposed +ollection 8eriod +han%e:".R.' 5ec. > PCCG'GGG 1sales3 ( 16GH>AG3UU

P 6F>'GGG

Less ".R. from statement 1aove3UUUUU.. A@'GGG"dditional cashneededUUUUUUUUUU.

6C'GGG

+ash e(cess 1aove3UUUUUUUUUUU.. CC'@GG+ash to eorrowedUUUUUUUUUUU..

P >F'@GG

c. What!If "nalysis of 8roposed 8ayment 8eriod +han%e:".8.' 5ec. > PA@B'GGG 1purch.3 ( 1AGH>AG3U. PGF'@GG".8. from statement 1aove3UUUUUUUU...

6??'GGG

"dditional cash neededUUUUUUUUUU >?'@GG+ash e(cess 1aove3UUUUUUUUUUU. CC'@GG+ash to e orrowedUUUUUUUUUUU. P ?A'GGG


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8rolem !? 1?G minutes3Top +orporation+ash 4orecast

4or 9ear Ended 5ecemer >' 9ear A+ash alance 1HH9ear A3UUUUUU.. P >@'GGG

+ash receipts:

"ccounts receivale' an. ..U... P B@'GGG)alesUUUUUUUUUUUUU. ?6'@GG"ccounts receivale' 5ec. > 1)ales' P?6'@GG ( FGH>AG3UU.. 1G>'6@3+ash receiptsU.UUUUUUUU >C?'>B@

Total cash availaleUUUUUUUU... P?F'>B@

+ash disursements:"ccounts payale' an. .UUU P A@'GGG8urchases UUUUUUUUU >>'B@G"ccounts payale' 5ec. > UUU 166'GGG3 6B?'B@G8ayment of notes payaleUUU. 6'@GG"ccrued ta(esUUUUUUUUU F'GGG+ash e(penses 6UUUUUUU G'6@G >FA'@GG

Estimated cash alanceUUUUUUU. P 66'CB@

/inimum cash alance desiredUUU. @G'GGGRequired to orrowUUUUUUUUU. P 6B'6@

-otes:

0e%innin% inventoryUUUUUUUU. P >6'GGGS 8urchases lu+.UUUUUUUUU >>'B@GKoods availale for sale.UUUUUU. >A>'B@G! Endin% inventoryUUUUUUUUU. B@'GGG+ost of sales 1P?6'@GG ( .BG3UUUU P6CC'B@G

6

Kross profit 1>GO of sales3UUUUUU P6>'B@G5epreciation 1P6@'GGG ! P6'@GG3UUU.. >'@GG-et income 1e(cludes other e(penses3.. 6G'6@G&ther e(penses 1plu%3UUUUUUU.U G'6@G-et income 1%iven3UUUUUUUUU... P G'GGG


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8rolem !@ 1AG minutes3

a. Relevant information that proaly can e derived from the notes to thefinancial statements includes:. 5etails of Kant#s an$ credit' includin% total line of credit' portion currently

unused' interest rates' and terms of credit.

6. Impacts of any consolidated susidiaries on the liquidity of theconsolidated alance sheet of Kant. )usidiaries usually maintain separatecredit facilitiesN therefore' solvency of a susidiary may not necessarily eaccessile to the parent company#s creditors.

>. Kant#s pension fundin% oli%ations. Is there an unfunded liaility If so'what are the future financial oli%ations

"dditional relevant information that you should attempt to otain from Kant#smana%ement includes:?. 8rior years; 1andHor quarterly3 statements of cash receipts and payments.@. 4orecasts statement 1one or more years3 of due dates and amounts for its

receivales and payales.A. 0ud%et of planned capital e(penditures.B. 0ud%et of planned lon%!term financin%.

. 2ualitative assessments that you would want to ma$e re%ardin% Kant+orporation and its industry include:. 4inancial fle(iility of Kant in terms of its aility to liquidate assets without

affectin% profitaility.6. Level of inflation 1prices chan%es3 applicale to Kant and its industry

1includin% those for raw materials' unioni7ed laor' product pricefle(iility3.

>. Kant#s competitiveness in the domestic industry 1that is' how up!to!date isits plant and equipment3. "lso' will major capital e(penditures e requiredin the near term

?. Dow does the industry and Kant compete internationally "re thereadverse international industry developments eyond the control of KantIn addition to these %eneral qualitative assessments of Kant' you would want toconsider the followin% more specific qualitative assessments:@. +ost +ontrol 8ro%ram:

Dow has the cost cuttin% pro%ram impacted its financial fle(iilityDow lean is its operations"re there assets that can e disposed of without impactin% productivity orprofitaility ne%ativelyDas the pro%ram een too intense such that lon%!term opportunities arelost

A. +ommodity &rientation of 8roduct Line:What has happened with commodity prices over the past several years

"re the mar$ets for Kant#s various product lines softB. ,.). 8lant 4acilities:Dow has the stren%thHwea$ness in the ,.). dollar affected the company#scompetitive position over the past yearsDow competitive is Kant internationallyWill it e forced to diversify its operations internationally andHor up%radeplant productivityDow would a major sustained capital e(penditure pro%ram affectsolvency

8rolem !A 1AG minutes3


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a.atio5 6ear 6ear

#

. +urrent ratio9ear @: PA'GGGHP?G'GGGUUUUUU. .@

9ear A: PC?'GGGHP@?'GGGUUUUUU. .A6. 5ays# sales in receivales

@: 1P6G'GGG H 1P@@'GGGH>AG3UUUU... ?AA: 1P6@'GGG H 1PCA'GGGH>AG3UUUU... ?C

>. Inventory turnover@: PFF'GGGH1P>6'GGGSP>C'GGG3H6UU.. 6.C>A: P6G'GGGH1P>C'GGGSP@A'GGG3H6UU 6.@@

?. 5ays# sales in inventory@: P>C'GGGH1PFF'GGGH>AG3UUUUUU. >CA: P@A'GGGH1P6G'GGGH>AG3UUUUU.. AC

@. 5ays# purchases in accounts payale

@: P6>'GGGH1PG@'GGGM H>AG3UUUUU BFA: P6F'GGGH1P>C'GGGM H>AG3UUUUU BA

7urchases 6ear 6ear #

+ost of salesUUUUUUUU... P FF'GGG P6G'GGGS Endin% inventoryUUUUUU >C'GGG @A'GGGKoods availale for saleUUU.. >B'GGG BA'GGG! 0e%innin% inventoryUUUU... >6'GGG >C'GGG8urchasesUUUUUUUUUU PG@'GGG P>C'GGG

A. +ash flow ratio@: PB'BGG H P?G'GGGUUUUUUU.U. G.FA: PA'?GG H P@?'GGGUUUUUUU.U. G.6

. /ost of the liquidity measures of XET" do not reveal any si%nificant chan%es from9ear @ to 9ear A. Dowever' there is some deterioration in the inventory turnover.This deterioration is even more evident in the days# sales in inventory measures./oreover' the liquidity inde( also su%%ests that the liquidity position of XET" hasdeteriorated from 9ear @ to 9ear A. "lso notice that ecause of a lower level ofoperatin% cash flows' the cash flow ratio shows a si%nificant decline. )till' due tothe short time span of this analysis' one would want to e(amine another year ortwo 1say' 9ears > and ?3 to see if these chan%es reflect a lon%er!term trend inliquidity.


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8rolem !B 1FG minutes3

a. )ummary of Ratio "nalysis Results:6ear 11 6ear 1& 6ear %

. Lon%!term det to equity capital.......................... .> .@ .G66. Total liailities to total liailities and equity....... G.BG G.AF G.A?

>. Total liailities to equity........................................ 6.>> 6.6A .B@?. 8referred stoc$ to total equity.............................. G.@>O G.CO !!@. Earnin%s covera%e of fi(ed char%es.................... ?.?@ >.B@ >.@BA. +ash flow covera%e of fi(ed char%es.................. A.C> @.6G @.A@B. +ash from operations to lon%!term det............. G.?@ G.>C G.>>C. Earnin%s covera%e of preferred dividends......... ?.66 >.@C >.@BF. Equity capital to net fi(ed assets......................... G.B> G.CC .F

)upportin% calculations:. Total det and Equity F6 Y )hort!term det BC ! EquityMM

EquityMM

MMEquity Q F S C6 S C> S C?

115 >'GA. ! F6A.F ! [email protected]@.C

1&5 >'>6A. ! '>C.@ ! 'GF.>GF.>

%5 >'[email protected] ! C6?. ! '>B.'>B.

6. +urrent liailities BC S Lon%!term detTotal liailities and equity F6

115 F6A.F S 'C>.?>'GA.

1&5 '>C.@ S 'AC.>>'>6A.

%5 C6?. S 'A?.B>'[email protected]

>. Total liailitiesTotal equity capital

115 1&5 %5

6'G.> 6'>GA.C '[email protected] 'GF.> '>B.


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?. 8referred stoc$ at stated value C6!C>!C? Total equity 1 aove3

115 GG ! F?.@ ! [email protected]

1&5 GG ! FC.6 ! G'GF.>

%5 GG ! GG ! G'>B.

-ote' if preferred stoc$ is at liquidatin% value' Then:

G.F@OGFG@'CGG'GG

FF'6>'G>A:

a

a-umer of shares issued and outstandin% C6' C? 1'6C6'G@ ! G'GCF3 ( PBC liquidatin% value

@. 8re!ta( income from cont. oper. B SInt e(p @A S Int portion of operatin% rentals@?

Interest incurred @A S Interest portion of operatin% rentals @?

115 ?.@ S G.F S ??.@H>G>.C S ??.@H>

1&5 >C6.? S 6G.6 S ??.>H>6> S ??.>H>

%5 6>F. S [email protected] S ?6.?H>BC. S ?6.?H>

A. &peratin% cash flows > S Income ta( e(penseM @C S 4i(ed char%es 1@ aove34i(ed char%es 1@ aove3

ME(cept deferred*already added ac$ in computin% +4&.

115 @>6.? S A.? S A.BC.A

1&5 ??B. S >?.F S >@>B.C

%5 >C.A S ?F.A S FGF6.6

B. +ash from operations >Lon%!term det 16 aove3

115 1&5 %5 @>6 .? ??B . >C .A'C>.? 'AC.> 'A?.B


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C. Income efore ta( B S 4i(ed char%es 1A aove34i(ed char%es 1@ aove3 S 8referred dividendH1 Y Ta( rate3

115 ?.@ S A.BC.A S ?.>H1 ! .>?3

1&5 >C6.? S >@

>B.C S ?.@H1 ! .>?3

%5 6>F. S FGF6.6 S GH1 ! .>?3

F. Equity capital 1 aove3 H 88E' net AA

115 1&5 %5

FG@ .C 'GF .> '>B .'6>6.B '@?. [email protected]

. The financial levera%e for 9ear indicates that use of levera%e has een

increasin%ly more advanta%eous for the common stoc$holder. The liaility!to!equity ratios indicate an unfavorale increase of more than 6O in 9ears and G. The cash flow covera%e ratio of fi(ed char%es has improved from alow level in 9ear G. The earnin%s covera%e of fi(ed char%es has e(hiitedsteady improvement' as has the ratio of cash from operations to lon%!termdet.


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8rolem !C 1B@ minutes3

a. +omputation of 9ear G capital structure and solvency ratios for +ampellrequires that we determine the followin% component measures for 9ear G:Lon%!term det:-otes payale................................................................................ P BF6.F

+apital lease oli%ations............................................................... 6 .FLon%!term det B6..................................................................... [email protected] income ta(es 1@GO3 BA.............................................. B.A&ther Liailities BB.................................................................... 6C.@+urrent Liailities ?@................................................................... '6FC .Total det....................................................................................... P6'[email protected] +apital:&wners# equity @?....................................................................... P'AF.C5eferred income ta(es 1@GO3 BA.............................................. B.A/inority interests BC................................................................. @A .>Total equity.................................................................................... P'[email protected]

. P6'[email protected] H P'[email protected] Q .66. P6'[email protected] H P?'@.B Q G.@@

>. [email protected] S PB.A S P6C.@3 H P'[email protected] Q G.@

?. P'[email protected] H P6'[email protected] Q G.C>

@. P'BB.B >B H P'[email protected] Q G.F6

A. P'6FC. H P6'[email protected] Q G.@CB.

umerator enominator

8reta( income 6A..................................................... BF.? !!Interest e(pense GG................................................ .A !!Int. with oper. leases 1H> of PA6.? ?>3.................. 6G.C 6G.CInterest incurred FC.................................................. 6.F,ndistriuted equity in earnin%s in non! consolidated sus. AF" 1P>.G! PB.?3.................. 1@ .A3 G .G>GA.6 ?6.B

Ratio Q P>GA.6 H P?6.B Q 6.?C.

umerator enominator

+ash from ops efore ta(M......................................... AF.@ !!Interest e(pense ........................................................ .A !!

Interest incurred ........................................................ !! 6.FInterest portion of op leases...................................... 6G .C 6G .C

[email protected] ?6.BM +4& A? P??C.? S +urrent ta( e(pense PB. 6?" Q PAF.@

Ratio Q [email protected] H P?6.B Q @.6B

F. P>AB.? H P6'[email protected] Q G.A

. We would compute the total det to total capitali7ation as follows:


>C.GORBC1f3P@A.>R@?3P'AF.C1e3P'GAF.?1d

RBA1c3P6>@.RBBP6C.@[email protected]

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1a3 Lon%!term det13 &ther liailities1c3 5eferred income ta(es 1assumin% GGO considered as liailities31d3 a S S c1e3 Total equity1f3 /inority interests

8roaly the closest we can come to reconstruct +ampell#s computation of>>.BO' item 6' is as follows: [email protected] S P6C.@3 H 1PC>?.> S P'AF.C3 Q >>O.This computation omits deferred ta(es and minority interests.


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8rolem !F 1?@ minutes3

a. . Ratio of Earnin%s to 4i(ed +har%es:Te(t reference -umerator 5enominator

1a3 8re!ta( income.................................................. P?'AGG P !!13 Interest e(pensed............................................. ?GG !!

1h3 Interest incurred............................................... !! ??G1d3 Interest part of operatin% rental e(pense...... 6G 6G1f3 "morti7ation of prior capitali7ed interest...... AG !!1%3 ,ndistri. inc. of Z@GO owned affiliates........ 1>GG 3 !!

P?'CCG P@AGRatio Q P?'CCG H P@AG Q C.B

6. Ratio of +ash 4rom &perations to 4i(ed +har%es:-umerator 5enominator

8re!ta( income....................................................... P?'AGG P !!

Add educt. ad9ustments:5epreciation........................................................... AGG !!"morti7ation of ond premium............................ 1>GG3 !!)hare of minority interest in income................... 6GG !!,ndistriuted income of affiliates....................... 1>GG3 !!Increase in accounts receivale........................... 1FGG3 !!5ecrease in inventory............................................ CGG !!Increase in accounts payale............................... BGG !!8re!ta( cash provided y operations.................. P@'?GG !!Int. e(p. 1P?GG3 S 0ond premium amor 1P>GG3..... BGG !!Interest incurred..................................................... ??G

Interest portion of capital leases......................... 6G 6GPA'66G P@AGRatio Q PA'66G H P@AG Q .

>. Earnin%s +overa%e of 8referred 5ividends:P?'CCG H [P@AG S P?GGH1 ! G.?G3 \ Q >.FC

. The company#s covera%e ratios su%%est the e(istence of sufficient earnin%sand cash flows to cover its fi(ed char%es. There is no evidence of concernfrom any of these three covera%e ratios. 4or a more complete analysis' we

would want to collect values from other firms 1competitors3 and additionalprior years for comparative analyses.


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8rolem !G

a. . Ratio of Earnin%s to 4i(ed +har%es:-umerator 5enominator

8re!ta( income....................................................... P@'CGG P !!Int. incurred Y int. capitali7ed 1CCGS>?G!6G3...... 'GG '66G

"morti7ation of ond discount............................ GG GGInterest portion of rental e(pense........................ ?GG ?GG"morti7ation of prior capitali7ed interest........... GG !!,ndistriuted inc. of Z@GO owned affiliates....... 1?GG3 !!)hare of minority interest..................................... AGG !!

PB'BGG P'B6GRatio Q PB'BGG H P'B6G Q ?.?C


8re!ta( income....................................................... P @'CGG P !!"dd ac$ e(penses not requirin% cash:5epreciation 1includes amorti7ation ofpreviously capitali7ed interest3............................ '6GG !!"morti7ation of ond discount............................ GG GG)hare of minority interest..................................... AGG !!5eferred ta(es*already added ac$.................. !! !!Increase in inventories.......................................... 16'GGG3 !!5ecrease in accounts receivale......................... 'AGG !!Increase in accounts payale............................... 6'GGG !!Less ,ndistriuted income of affiliates.............. 1?GG3 !!

8re!ta( cash provided y operations.................. C'FGG !!Interest e(pensed*ond discount add ac$..... 'GG !!Interest portion of rental e(pense........................ ?GG ?GGInterest incurred 1'66G S GG3.............................. '>6G

PG'?GG P'B6GRatio Q PG'?GG H P'B6G Q A.G?

>. Earnin%s +overa%e of 8referred 5ividends:Ratio Q PB'BGG H [P'B6G S P?GGH1 ! .?G3 \ Q >.6>

. The company#s covera%e ratios su%%est the e(istence of sufficient earnin%s

and cash flows to cover its fi(ed char%es. There is no evidence of concernfrom any of these three covera%e ratios. 4or a more complete analysis' wewould want to collect values from other firms 1competitors3 and additionalprior years for comparative analyses.


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8rolem ! 1?G minutes3

a. . Ratio of Earnin%s to 4i(ed +har%es:-umerator 5enominator

8re!ta( income....................................................... PA'6GG P !!Interest e(pense 1CCG S >?G ! 6G3....................... 'GG !!

Interest incurred 1CCG S >?G3................................. !! '66G"morti7ation of ond discount............................ GG GGInterest portion of rental payments..................... ?GG ?GG"morti7ation of capitali7ed interest..................... CG !!,ndistriuted income of Z@GO owned affiliates. 1AGG 3 !!

PB'6CG P'B6GRatio Q PB'6CG H P'B6G Q ?.6>


8re!ta( income....................................................... PA'6GG P !!

"dd 1deduct3 items to convert to cash asis:5epreciation........................................................... '6GG !!"morti7ation of ond discount ........................... GG !!/inority interest in income................................... AGG !!,ndistriuted income of affiliates....................... 1AGG3 !!+han%es in:

"ccounts receivale............................................ AGGInventories............................................................ 1AG3 !!8ayale and accrued e(penses......................... 6G !!

8re!ta( cash from operations............................... C'GAG !!Interest incurred 1CCG S >?G3................................. !! '66G

"morti7ation of ond discount............................ !! GGInterest e(pense 1CCG S >?G ! 6G3....................... 'GGInterest portion of rental e(pense........................ ?GG ?GG

PF'@AG P'B6GRatio Q PF'@AG H P'B6G Q @.@A

>. Earnin%s covera%e of preferred dividends:Ratio Q PB'6CG H [P'B6G S P?GGH1 ! .?G3 \ Q >.G@

. 0ased on the calculations in part a' the supervisor#s concerns aout thecovera%e ratios are misplaced. Indeed' the company#s covera%e ratiossu%%est the e(istence of sufficient earnin%s and cash flows to cover its fi(ed

char%es. There is no evidence of concern from any of these three covera%eratios. 4or a more complete analysis' we would want to collect values fromother firms 1competitors3 and additional prior years for comparative analyses.

8rolem !6 1@G minutes3


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Interest incurred calculation:4irst /ort%a%e 0onds: @.GO of B'@GG Q >B@

A.GO of B'@GG Q 'G@G '?6@)in$in% 4und 5eentures A.@O of G'GGG Q A@G

Total interest incurred P6'GB@

a. Earnin%s +overa%e Ratio on the 4irst /ort%a%e 0onds 1pre!ta( asis3:13 >.> ased on 9ear B earnin%s' 1P?'B@G H P'?6@3163 >. ased on @!year avera%e' [1P?'B@GSP?'@GGSP?'@GGSP?'6@GSP?'GGG3H@\H

P'?6@

Earnin%s +overa%e Ratio on the )in$in% 4und 5eentures 1pre!ta( asis3:13 6.> ased on 9ear B earnin%s' 1P?'B@G H P6'GB@3163 6. ased on @!year avera%e' [1P?'B@GSP?'@GGSP?'@GGSP?'6@GSP?'GGG3H@\H

P6'GB@

. Lon%!Term 5et to Equity Ratio:Ratio Q P>@HPC6 Q G.?> ?>O of capital is det

&f equity capital' >FO 1P6G'GGGMHP@'@GG3 is senior to common stoc$M P.G preferred 1>GG'GGG ( P6G3..................................... P A'GGG

+lass " shares................................................................. ?'GGGP6G'GGG

c. Earnin%s +overa%e Ratio on the +umulative Redeemale 8referred:Interest requirements for lon%!term det........................................... P6'[email protected] preferred dividend*ta( adjusted 1>GG'GGG31P.3H1!.@G3..... AAGRequired pre!ta(.................................................................................... P6'B>@

13 .B Q ased 9ear B earnin%s' 1P?'B@G H P6'B>@3163 .A Q ased on @!year avera%e' 1P?'?GG H P6'B>@3

d. Earnin%s per )hare +omputation "ssumin% +onversion:P?'B@G 9ear B earnin%s efore interest and ta(es16'GB@3 Interest e(penseP6'AB@ 8re!ta( income1'>>B3 Ta(es 1@GO3P'>>C "fter!ta( income 1>>G3 P.G preferred dividends 1>GG'GGG shares ( P.G3P'GGC "vailale for common shareholders

.C mil +ommon shares mil. S G.C mil. 1+lass " +onversion3P G.@A Earnin%s per share


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8rolem !> 1?@ minutes3

a. +omputation of Income and E8) under 5et vs. Equity 4inancin%:

e/t E!uity

Income efore interest and ta(es*pre!e(pansion......... P6G'GGG'GGG P6G'GGG'GGG

"dditional income from e(pansion................................... ?'GGG'GGG ?'GGG'GGGIncome efore interest and ta(es*post!e(pansion....... 6?'GGG'GGG 6?'GGG'GGGInterest e(pense 1AO31P6G'GGG'GGG3SP'GGG'GGG............. 16'6GG'GGG 3 1'GGG'GGG 3Income efore ta(es.......................................................... 6'CGG'GGG 6>'GGG'GGGIncome ta(es 1?GO3........................................................... 1C'B6G'GGG3 1F'6GG'GGG3-et income P>'GCG'GGG P>'CGG'GGG

+ommon shares outstandin%........................................... 6'GGG'GGG 6'?GG'GGGEarnin%s per share............................................................ PA.@? [email protected]@

. +omputation of E8) Equality etween 5et and Equity 4inancin%:

M E0IT Q Earnin%s 0efore Interest and Ta(es.

)olvin% for E0IT yields:

E0IT Q PC'6GG'GGG

Interpretation: When income efore interest and ta(es is at PC'6GG'GGG'mana%ement is indifferent etween the det or equity financin% plans.

8rolem !? 1@@ minutes3

a. . :uaranteed Su/sidiary e/t. "dd P6@G'GGG'GGG to oth lon%!term det and tofi(ed assets. Rationale: ,nder the equity method of accountin% for jointventures' the det incurred is not reported on the alance sheet of thepartners and therefore' this det should e reflected in the adjusted det ratiosince Luoc$ has %uaranteed the total indetedness of the joint venture.

6. ;IF< eserve. "dd P6GG'GGG'GGG to oth inventory and to retained earnin%s1i%norin% potential ta( effects3. Rationale: ,nder LI4& accountin%' Luoc$will report current costs for inventory transactions in its income statement utits alance sheet amount for endin% inventory will reflect

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approach is to reco%ni7e a deferred ta( liaility of P6GG'GGG ( current mar%inalta( rate.

>. ' mar$etalesecurities were valued at the lower of cost or mar$et under SFAS 12 1formar$etale equity securities3 and A 43 1for mar$etale det securities3.5urin% this period the mar$et value of securities were sometimes sustantiallyhi%her than shown on the alance sheet' requirin% analytical adjustment.,nder current practice' all mar$etale securities 1e(cept held!to!maturity detsecurities3 are valued at mar$et. Dence' only held!to!maturity det securitiesare potentially suject to mar$et adjustment. 1ii3 "n analyst must reali7e thatthe lon%er the elapsed time since the alance sheet date the %reater theli$elihood that mar$et values for mar$etale securities have chan%ed. Dence'for comparative analysis spannin% several years' adjustments to mar$et maye necessary for investment securities.

6. 5eferred income ta(es are created when a company uses different accountin%methods for income ta( and financial reportin% such that so!called timin%differences in income occur. &ne school of thou%ht ar%ues that deferred ta(esshould e reco%ni7ed as a liaility. The presumption is that timin% differenceswill reverse in the future and the ta(es will ecome payale or that chan%es inthe ta( law could accelerate payment of such ta(es. &pponents ar%ue thatdeferred ta(es should e included in shareholders# equity. The presumptionhere is that timin% differences are unli$ely to reverse and therefore the alancein deferred ta(es will continue to %row and not ecome payale. This meansthat the lon%!term det ratio of a company would e adversely affected ifdeferred ta(es are considered lon%!term det 1first viewpoint3N however' thisratio would e favoraly impacted if such ta(es are considered as part ofshareholders# equity 1second viewpoint3.


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>.?6PAP6 GGGP@ GGG

P'GGGP'GGGPAP6'GGGP?'GGGPA'GGGdc%

eca

8rolem !@ 1B@ minutes3

a. Ratio +omputations:

. 9ear @: P@B'6GGaH PG@'GGGQ G.@@9ear A: PC6'AGGaH P>C'GGGQ G.AG

aIncludes: 13 Total current liailities'163 Lon%!term det due after one year' and1>3 5eferred income ta(es

Includes: 13 "ll items in 1a3 aove' as well as163 /inority interest' and1>3 )toc$holders# equity

6. 9ear @: P@B'6GG H P?B'GGG Q .669ear A: PC6'AGG H P@?'GGG Q .@>

>. 9ear @: PB'6GGaH P?B'CGGQ .>A

9ear A: P6C'AGGaH P@@'?GGQ .@6aIncludin% deferred ta(es.)toc$holders# equity S minority interest.

?. 9ear @:

M Loss per income statement 1additional >GG added ac$ in )+4 represents dividendsreceived3.

9ear A:

MM4rom the statement of cash flows 1income minus dividends received3. a8re!ta( income Interest incurred ! interest capitali7ed c"morti7ation of ond discount dInterest portion of operatin% rental e(pense e"mount of previously capitali7ed interest amorti7ed in this period f

Reversal of undistriuted income 1loss3 of associated companies %Interest incurred


6.AP6GP6'@GGPF'6CG

MMP'?GG!P'6GGP6GP6'@GGPB'?6GP6'GGGd% c

fedca

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@. +ash from operationsM S income ta( e(pense 1e(cept deferred ta(es3S fi(edchar%esMM

4i(ed char%esMM

M 5epreciation added ac$ already includes amorti7ation of interest previouslycapitali7ed.

MM"s computed in 1?3 aove.

9ear @: PB'BGG S 1PB'CGG!P'GGG3 S PB'GA H PB'GA Q >.GB9ear A: PA'?GGS1PG'GGG!P'AGG3SP'CGGH P'CGG Q 6.6@

. "nalysis and Interpretation:The financial levera%e inde(' which underwent only minimal chan%e' is at alevel su%%estive of levera%e enefits to XET"#s stoc$holders. There also haseen a mar$ed increase in levera%e as is indicated y the total det to equityand the lon%!term det to equity measures. With total liailities e(ceedin%

equity y over @G percent' the level of liailities is si%nificant. The relation oflon%!term det to equity is at a somewhat lower level. The earnin%s and cashflow covera%e of fi(ed char%es are low on an asolute asis and havedeclined from 9ear @ to 9ear A. This decline is primarily ecause fi(ed char%esincreased faster than net income. 4inally' operatin% cash flows

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241487536-FSA-8e-Ch11-SM