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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
Comments on Specific Pages from the Chapter (cont.)
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
Comments on Specific Pages from the Chapter (cont.)
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
Comments on Specific Pages from the Chapter (cont.)
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
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 5-17
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
Analysis of Razzle-Dazzle Electronics: Ratios
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 5-19
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
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$269 $306
Changes in Accounts Receivable ($142) ($169)
Changes in Inventory ($125) ($174)
Changes in Trade Payables $107 $130
Changes in Accruals $29 $34
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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)
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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)
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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