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 standpoint 2. Practical ways the debtor may manage overall liquidity 1. Holding more cash 2. Extra borrowing capacity 3. 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 Ratios 1. Comparison to Standards a. Standards and rules of thumb b. Standards and “best practice” 2. Trend Analysis a. Graphing example (slide 5-4) b. Computing the ratio over time c. 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 Corporation Comparison of Current and Quick Ratios Slide 5-9

Sage Corporation Comparison of DIH and CCC Slide 5-10

Sage Corporation Debt to Assets Comparison 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-Dazzle Some 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 Average 2013 Liquidity Current Ratio (graph on Slide 5-16) Quick Ratio (graph on Slide 5-16) Cash Flow Liquidity Ratio Not Avail. Accounts Receivable: Accounts Receivable Turnover Average Collection Period (days) (graph on Slide 5-18) Inventory Inventory Turnover based on CGS Days Inventory Held (graph on Slide 5-18) Sum of ACP and Days Inv. Held Debt Ratios Total Debt/Total Assets 58.76% 64.49% 69.48% 57.30% (graph on Slide 5-20) Total Debt/Equity Slide 5-15

Razzle-Dazzle Current and Quick Ratios Slde 5-16

Analysis of Razzle-Dazzle Electronics: Ratios Industry Year Average 2013 Liquidity Current Ratio (graph on Slide 5-16) Quick Ratio (graph on Slide 5-16) Cash Flow Liquidity Ratio Not Avail. Accounts Receivable: Accounts Receivable Turnover Average Collection Period (days) (graph on Slide 5-18) Inventory Inventory Turnover based on CGS Days Inventory Held (graph on Slide 5-18) Sum of ACP and Days Inv. Held Debt Ratios Total Debt/Total Assets 58.76% 64.49% 69.48% 57.30% (graph on Slide 5-20) Total Debt/Equity Slide 5-17

Razzle-Dazzle Electronics: ACP and DIH Slide 5-18

Analysis of Razzle-Dazzle Electronics: Ratios Ratios Industry Year Average 2013 Liquidity Current Ratio (graph on Slide 5-16) Quick Ratio (graph on Slide 5-16) Cash Flow Liquidity Ratio Not Avail. Accounts Receivable: Accounts Receivable Turnover Average Collection Period (days) (graph on Slide 5-18) Inventory Inventory Turnover based on CGS Days Inventory Held (graph on Slide 5-18) Sum of ACP and Days Inv. Held Debt Ratios Total Debt/Total Assets 58.76% 64.49% 69.48% 57.30% (graph on Slide 5-20) Total Debt/Equity Slide 5-19

Razzle-Dazzle Electronics Debt to Assets Slide 5-20

Razzle-Dazzle Electronics: Cash Flow Analysis Year Cash Flow from Operations Calculations: Cash flow from income statement Earnings after Taxes $144 $150 Depreciation Addback $125 $ $269 $306 Changes in Accounts Receivable ($142) ($169) Changes in Inventory ($125) ($174) Changes in Trade Payables $107 $130 Changes in Accruals $29 $ Total Adjustments ($131) ($179) Cash Flow from Operations $138 $127 Slide 5-21

Cash Flow Analysis (cont.) Year 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 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 $ % $ % Outflows Changes in Gross Equipment $250 68% $312 72% Dividends Paid $115 32% $120 28% Total Cash Outflows $ % $ % 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