Financial Statement Analysis I: Chapter 5

Financial Statement Analysis I:Chapter 5

Important Decisions by the Debtor that Affect Credit Risk

A. The Capital Structure Decision (Debt/Equity)

1. Relative Costs of Debt and Equity Financing

a. Risk and required returns

b. Tax deductibility of interest

2. Effects on Debtor Riskiness

3. Capital Structure Choice and the Small Firm

Slide 5-1

Important Decisions by the Debtor that Affect Credit Risk (cont.)

B. The Overall Liquidity Decision 1. Tradeoff from the debtor’s standpoint2. Practical ways the debtor may

manage overall liquidity

1. Holding more cash2. Extra borrowing capacity3. Borrowing long-term instead

of short-term

Some General Comments on Ratio Analysis A. History of Ratio Analysis

B. Centering on Ratios that Are Relevant for You

C. Ways of Using Ratios1. Comparison to Standards

a. Standards and rules of thumbb. Standards and “best practice”

2. Trend Analysisa. Graphing example (slide 5-4)b. Computing the ratio over timec. Accounting and other time conventions

Slide 5-3

Graphing and Trend Line Example

Slide 5-4

Comments on Specific Pages from the Chapter

A. Three Questions in Dealing with Borrowing

1. What is the Cause?

2. What is the Borrower’s Capital Structure?

3. How Will Debt Be Repaid?

B. Sources of Ratio Data and Other Information

1. Sources for Publicly-Traded Firms

2. Minor Notes on the Chapter

a. The Meaning of an Auditor’s Report

b. Financial Analysis Software

c. Sources of Ratio Data on Non-traded Firms

Slide 5-5

Comments on Specific Pages from the Chapter (cont.)

C. Ratio Types and General Uses

D. Alternative Ways of Computing Ratios: Averages

versus Year-End Figures

E. Important Ratios for the Creditor: Liquidity and Debt

1. The Current Ratio

a. The current ratio and rules of thumb

b. Problems with the current ratio

as a liquidity measure

2. The Quick Ratio

3. The Cash Flow Liquidity Ratio

Slide 5-6


E. Important Ratios for the Creditor: Liquidity and Debt (cont.)

4. The Average Collection Period (ACP)

1. ACP and AR turnover: Ratios giving

the same information

AR turns = 365/ACP; ACP = 365/AR turns

2. Accounts receivable management strategies

from the debtor’s perspective

3. AR management from the creditor’s perspective

5. Days Inventory Held (DIH)

6. Days Payable Outstanding and Its Limitations

7. The Cash Conversion Cycle (CCC)

8. Activity Ratios

9. Useful Debt Ratios: Debt/Assets and Debt/Equity

Slide 5-7


F. Perspectives in Interpreting Ratios

G. Another Problem in Using Ratios that Are

Ordered by the Accountant’s Method

H. Dealing with Missing Industry Average Ratios

I. Some Ratio Analysis of Sage Inc.

from the Trade Creditor’s Perspective

Slide 5-8

Sage CorporationComparison of Current and Quick Ratios

Sage CorpCurrent and Quick Ratios

Year 2009 2010 2011 2012 2013Current Ratio 2.83 2.18 2.26 2.75 2.40Quick Ratio 1.20 1.22 0.87 0.95 0.68Ind. CR 2013 2.53Ind. QR 2013 0.97

0.00

0.50

1.00

1.50

2.00

2.50

3.00

2009 2010 2011 2012 2013

Quick Ratio

Current Ratio

Ind. CR 2013

Ind. QR 2013

Slide 5-9

Sage CorporationComparison of DIH and CCC

Sage CorpDays Inventory Held (DIH) and Cash Conversion Cycle (CCC)

Year 2009 2010 2011 2012 2013DIH 114 122 134 146 133CCC 89 99 110 133 107Ind. DIH 2013 117Ind. CCC 2013 102

0

20

40

60

80

100

120

140

160

2009 2010 2011 2012 2013

CCC

DIH

Ind. DIH 2013

Ind. CCC 2013

Slide 5-10

Sage CorporationDebt to Assets Comparison

Sage CorpDebt to Assets

Year 2009 2010 2011 2012 2013Debt to Assets (percent) 39.7 40.8 49.2 50.1 51.8Ind. Debt/Assets 2013 48.7

0

10

20

30

40

50

60

2009 2010 2011 2012 2013

Debt to Assets(percent)

Ind. Debt/Assets 2013

Slide 5-11


J. Profitability Ratios and the Du Pont System

K. Financial Projections

Slide 5-12

Razzle-DazzleSome Initial Questions to ask Razzle-Dazzle:

Were the statements prepared using accounting software, and if so, what software? Did the firm enter the numbers into the software or did the accountant?

Are any assets or financing used by the business but do not appear on the financial statements?

How is inventory valued?

Is there a reserve for bad debts?

Slide 5-13

Some Initial Questions to ask Razzle-Dazzle (cont.)

How are the short term bank loans and the long term debt secured? By a lien on the property plant and equipment, or by a lien against all assets?

Have the firm’s owners given a guarantee of account to any creditors?

Slide 5-14

Analysis of Razzle-Dazzle Electronics: Ratios

Industry

Year 2011 2012 2013 Average 2013

Liquidity

Current Ratio 1.267 1.296 1.272 1.700 (graph on Slide 5-16)

Quick Ratio 0.460 0.493 0.483 0.900 (graph on Slide 5-16)

Cash Flow Liquidity Ratio 0.247 0.135 Not Avail.

Accounts Receivable:

Accounts Receivable Turnover 21.37 15.29 12.13 7.80

Average Collection Period (days) 17.08 23.87 30.08 46.79 (graph on Slide 5-18)

Inventory

Inventory Turnover based on CGS 5.38 5.19 4.88 6.00

Days Inventory Held 67.79 70.28 74.83 60.83 (graph on Slide 5-18)

Sum of ACP and Days Inv. Held 84.87 94.15 104.91 107.62

Debt Ratios

Total Debt/Total Assets 58.76% 64.49% 69.48% 57.30% (graph on Slide 5-20)

Total Debt/Equity 1.43 1.82 2.28 1.34

Slide 5-15

Razzle-DazzleCurrent and Quick Ratios

Razzle Dazzle ElectronicsCurrent and Quick Ratios

Year 2011 2012 2013Current Ratio 1.27 1.30 1.27Quick Ratio 0.46 0.49 0.48Ind. CR 2013 1.70Ind. QR 2013 0.90

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

1.80

2011 2012 2013

Quick Ratio

Current Ratio

Ind. CR 2013

Ind. QR 2013

Slde 5-16


Industry

Year 2011 2012 2013 Average 2013

Liquidity







Inventory




Debt Ratios



Slide 5-17

Razzle-Dazzle Electronics:ACP and DIH

Razzle Dazzle ElectronicsAverage Collection Period (ACP and Days Inventory Held (DIH)

Year 2011 2012 2013DIH 67.79 70.28 74.83ACP 17.08 23.87 30.08Ind. DIH 2013 60.83Ind. ACP 2013 46.79

0

10

20

30

40

50

60

70

80

2011 2012 2013

ACP

DIH

Ind. DIH 2013

Ind. ACP2013

Slide 5-18


Ratios

Industry

Year 2011 2012 2013 Average 2013

Liquidity







Inventory




Debt Ratios



Slide 5-19

Razzle-Dazzle ElectronicsDebt to Assets

Razzle Dazzle ElectronicsDebt to Assets

Year 2011 2012 2013Debt to Assets (percent) 58.76% 64.49% 69.48%Ind. Debt/Assets 2013 57.30%

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

70.00%

80.00%

2011 2012 2013

Debt to Assets(percent)

Ind.Debt/Assets2013

Slide 5-20

Razzle-Dazzle Electronics:Cash Flow Analysis

Year 2011-12 2012-13

Cash Flow from Operations Calculations:

Cash flow from income statement

Earnings after Taxes $144 $150

Depreciation Addback $125 $156

----- -----

$269 $306

Changes in Accounts Receivable ($142) ($169)

Changes in Inventory ($125) ($174)

Changes in Trade Payables $107 $130

Changes in Accruals $29 $34

----- -----

Total Adjustments ($131) ($179)

Cash Flow from Operations $138 $127

Slide 5-21

Cash Flow Analysis (cont.)

Year 2011-12 2012-13

Cash Flows from Investing

Changes in Gross Equipment ($250) ($312)

----- -----

Cash Flows from Investing ($250) ($312)

Cash Flows from Financing

Change in Short Term Bank Debt $11 $48

Change in Current Long Term Debt $13 $25

Change in Term Loans $167 $167

Dividends Paid ($115) ($120)

----- -----

Cash Flows from Financing $76 $120

Change in Cash Balance ($36) ($65)

Slide 5-22

Razzle-Dazzle Electronics: Summary Cash Flow Analysis

Year 2011-12 2012-13

Inflows

CFFO $138 42% $127 35%

Change in Short Term Bank Debt $11 3% $48 13%

Change in Current Long Term Debt $13 4% $25 7%

Change in Term Loans $167 51% $167 46%

----- ---- ----- ----

Total Cash Inflows $329 100% $367 100%

Outflows

Changes in Gross Equipment $250 68% $312 72%

Dividends Paid $115 32% $120 28%

----- ---- ------ -----

Total Cash Outflows $365 100% $432 100%

Change in Cash $(36) $(65)

Slide 5-23

Some Post-Analysis Questions to ask Razzle-Dazzle

Did the firm change policies for accounts receivable

and inventory? Will these new policies continue?

How does the firm intend to finance growth in these

assets?

Will payments of dividends be reduced?

Implications of the Firm’s Strategies and their Effects on Credit-Worthiness

Slide 5-24

Documents

Financial Statement Analysis I: Chapter 5