Credit Analysis Liquidity

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BWFF 5033FINANCIAL REPORTING AND STATEMENT

ANALYSIS

CHAPTER 10:CREDIT ANALYSIS ( LIQUIDITY )

PRESENTED BY:MUSFIRAH MAZLAN 818112

YULFAIZAH MOHD YUSOFF 817158NOR NASUHA AZIZAN 817259

1)LIQUIDITY AND WORKING CAPITAL2)OPERATING ACTIVITY ANALYSIS OF LIQUIDITY3)ADDITIONAL LIQUIDITY MEASURES

CONTENT

PART I:

Liquidity and Working Capital

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Ability to convert assets into cash or to obtain cash to meet short-term obligations.

Short-term - Conventionally viewed as a period up to one year.

Lack of liquidity can limit:

- Advantages of discounts - Profitable opportunities - Management actions - Coverage of current obligations

LIQUIDTY

1) Widely used measure of liquidity.

2) The excess of current assets over current liabilities.

3) Important due to following:-a) As a measure of liquid assets that provide a safety cushion to creditorsb) For measuring the liquid reserve available to meet contingencies and the uncertainties surrounding a company’s balance of cash inflows and outflows.

Working Capital

CURRENT ASSETS CURRENT LIABILITIES

Cash and other assets reasonably expected to be :-

(1)realized in cash, or

(1)sold or consumed, during the longer of one-year or the operating cycle.

Obligations expected to be satisfied within a relatively short period,

usually a year.

TYPES

Working capital measure of liquidity

Current ratio measure of liquidity:

The current ratio is 3:1 ($300,000/$100,000) for Company A and 1.2:1 ($1,200,000/$1,000,000) for Company B.

This ratio reveals a different picture for companies A and B. The ability to differentiate between companies on the basis of liquidity helps account for the widespread use of the current ratio.


•Liquidity depends to a large extent on prospective cash flows and to a lesser extent on the level of cash and cash equivalents.

•No direct relation between balances of working capital accounts and likely patterns of future cash flows.

•Managerial policies regarding receivables and inventories are directed primarily at efficient and profitable asset utilization and secondarily at liquidity.

•Two elements integral to the use of current ratio:– Quality of both current assets and current liabilities.– Turnover rate of both current assets and current liabilities.

Current Ratio

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• Comparative Analysis –Trend analysis

• Ratio Management (window dressing)–Toward close of a period, management will occasionally press the collection of receivables, reduce inventory below normal levels, and delay normal purchases.

• Rule of Thumb Analysis (2:1)–Current ratio above 2:1 - superior coverage of current liabilities (but not too high - inefficient resource use and reduced returns)–Current ratio below 2:1 - deficient coverage of current liabilities

• Note of caution–Quality of current assets and the composition of current liabilities are more important in evaluating the current ratio.–Working capital requirements vary with industry conditions and the length of a company’s net trade cycle.

Current Ratio - Applications

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IllustrationSelected information from Technology Resources for the end of Year 1:Sales for Year 1 $360,000Receivables 40,000Inventories* 50,000Accounts payable† 20,000Cost of goods sold (including depreciation of $30,000) 320,000

*Beginning inventory is $100,000.†These relate to purchases included in cost of goods sold.

We estimate Technology Resources’ purchases per day as:Ending inventory $ 50,000Cost of goods sold 320,000

370,000Less: Beginning inventory (100,000)Cost of goods purchased and manufactured 270,000Less: Depreciation in cost of goods sold (30,000)Purchases $240,000

Purchases per day = $240,000/360 = $666.67

Net Trade Cycle Analysis:

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– Net Trade Cycle is computed as:

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• Cash to Current Assets Ratio

Larger the ratio, the more liquid are current assets

• Cash to Current Liabilities Ratio

Larger the ratio, the more cash available to pay current obligations

Cash-Based Ratio Measures of Liquidity

Cash + Cash equivalents + Marketable securities Current Assets

Cash + Cash equivalents + Marketable securities Current Liabilities

PART II:

Operating Activity Analysis of Liquidity

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• Operating activity measures of liquidity are important in credit analysis.

• Operating analysis measures consists of three items which is account receivable, inventory and current liabilities.

1) Account Receivable Liquidity Measures:

- for company selling on credit, accounts and notes receivable are an important part of working capital.

- in assessing liquidity, it is necessary to measure the quality and liquidity of receivable where both are affected by their turnover rate.

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• Accounts Receivable Turnover

• Days’ Sales in Receivables

• Receivables collection period

Accounts Receivable Liquidity Measures:

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Account receivable turnover

Consumer Electronic reports sales of $1200000, beginning receivable of $150000 and year end receivables of $250000.

Account Receivable Turnover

= Net sales on credit

Avg. Account Receivable

= $1200000

($150000 + $250000)/2

= 6#

Example:

Day’s Sales in Receivables

Consumer Electronic reports sales of $1200000, beginning receivable of $150000 and year end receivables of $250000.

Day’s Sales in Receivable

= Account Receivable / Sales

360

= $250000

$1200000/360

= 75 days#

Example:


• Accounts receivable turnover rates and collection periods are usefully compared with industry averages or with credit terms.

• Example: if usual credit term of sales are 40 days, then an average collection period of 75 days is showing that poor collection efforts delay in customer payments customer in financial distress

Interpretation of Receivables Liquidity Measures

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2) Inventory Turnover Measures:

-Inventories are investments made for purposes of obtaining a return through sales to customers.

If inventory is inadequate, sales volume declines below an attainable level.

Excessive inventory shows a company to storage costs, insurance, taxes, obsolescence and physical deterioration.

Funds can be used more profitable elsewhere.

• Inventory turnover ratio:

– Measures the average rate of speed at which inventories move through and out of a company.

• Days’ Sales in Inventory:

– Shows the number of days required to sell ending inventory

• An alternative measure - Days to sell inventory ratio:

Inventory Turnover Measures

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Example: (Days’ Sales in Inventory)

Financial information from Macon Resources for Year 8:

Sales…………………………. $1800000

Cost of Goods Sold………… $1200000

Beginning inventory……….... $200000

Ending inventory……………. $400000

Days’ Sales in Inventory

= Inventories / Cost of Goods Sold

360

= 400000

$1200000/360

= 120 days#

Quality of inventory: refer to a company’s ability to use and dispose of inventory. (basically company does not use inventory for paying current liabilities – cuts into sales volume)

–Decreasing inventory turnover • Analyze if decrease is due to inventory build up in anticipation of

sales increases, contractual commitments, increasing prices, work stoppages, inventory shortages, or other legitimate reason.

–Effective inventory management increases inventory turnover.

Interpreting Inventory Turnover

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– Conversion period or operating cycle where combines the collection of receivables with the days to sell inventories to obtain the time interval to convert inventories to cash.

Interpreting Inventory Turnover:

It takes 195 days for a company to both sell its inventory and to collect the receivables based on current levels of receivables and inventories.

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3) Liquidity of Current Liabilities:

- CL are important in computing both working capital and the current ratio

i) to determine whether the excess of current assets over current liabilities affords a sufficient margin of safety.

ii) CL are deducted from current assets in arriving at working capital.

- Quality of CL

i) Must be judged on their degree of urgency in payment

Ii) Must be aware of unrecorded liabilities having a claim on current funds


• Days’ Purchases in Accounts Payable

–Measures the extent accounts payable represent current and not overdue obligations.

• Accounts Payable Turnover

–Indicates the speed at which a company pays for purchases on account.

Days’ Purchases in Accounts Payable

PART III:

Additional Liquidity Measures

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Current Assets Composition: Indicator of Working Capital Liquidity

Example :Texas Electric’s current assets along with their common-size percentages are reproduced below for Years 1 and 2:

Cash $ 30,000 30 % $ 20,000 20 %Accounts receivable 40,000 40 30,000 30Inventories 30,000 30 50,000 50 %Total current assets $100,000 100 % $100,000 100 %

An analysis of Texas Electric’s common-size percentages reveals a marked deterioration in current asset liquidity in Year 2 relative to Year 1. This is evidenced by a 10% decline for both cash and accounts receivable.

Year 1 Year 2


Acid Test Quick Ratio – A more stringent test of liquidityCash + Cash Equivalents + Marketable Securities + Account Receivables

Current Liabilities

Cash Flow Measures

- Cash Flow Ratio

Operating Cash Flow Current Liabilities

- Overcomes the static nature of the current ratio since its numerator reflects a flow variable

Financial Flexibility - Ability to take steps to counter unexpected interruptions in the flow of funds To borrow from various sources To raise equity capital To sell and redeploy assets To adjust the direction level of operations

Management’s Discussion and Analysis- MD&A requires a discussion of liquidity Known Trends Demands Commitments Uncertainty


Basics of Solvency

• Solvency – long run financial viability and its ability to cover long term obligation

• Capital Structure – Financing sources and their attribute

• Earning Power – Recurring ability to generate income from operation

• Loan Covenants – Protection against insolvency and financial distress

• 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

• When the proportion of debt financing is higher, the higher are the resulting fixed charges and repayment commitments

Capital Structure

Basics of Solvency

• Total Debt to Total Capital Ratio– Comprehensive measure of the relation between total debt and total capital – Also called Total debt ratio

• Total Debt to Equity Capital

• Long-Term Debt to Equity Capital– Measures the relation of LT debt to equity capital.– Commonly referred to as the debt to equity ratio.

• Short-Term Debt to Total Debt

– Indicator of enterprise reliance on short-term financing. – Usually subject to frequent changes in interest rates.

Capital Structure Ratio:

– Earnings power measures provide insight into the ability of a company to meet its fixed charges

– High correlation between earnings-power measures and default rate on debt

– Earnings variability and persistence is important– Use earnings before discontinued operations, extraordinary

items, and cumulative effects of accounting changes for single year analysis — but, include them in computing the average coverage ratio over several years

Earning Power:

Basics of Solvency

Earning to Fixed Charges:

• Limitation of capital structure measures - inability to focus on availability of cash flows to service debt.

• Role of earnings coverage, or earning power, as the source of interest and principal repayments.

• Earnings to fixed charges ratio

Basics of Solvency

Time Interest Earned Ratio:– Considers interest as the only fixed charge needing earnings

coverage:

– Numerator sometimes referred to as earnings before interest and taxes, or EBIT.

– Potentially misleading and not as effective an analysis tool as the earnings to fixed charges ratio.

Cash Flow to Fixed Charge Ratio:

– Computed using cash from operations rather than earnings in the numerator of the earnings to fixed charges ratio.

Earning Power of Preferred Dividends Ratio:

– Computation must include in fixed charges all expenditures taking precedence over preferred dividends.

– Since preferred dividends are not tax deductible, after-tax income must be used to cover them.

Basics of Solvency

THANK YOU

04/22/23

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Credit Analysis Liquidity