Financial Statement Analysis Summary

Definitions

Cash Conversion Cycle/Operating Cycle is the average time between purchase of raw materials and collection of cash for sales

Holding Again (Inventory Profit) is the difference between the original cost of the item and the cost of replacing it with new inventory Inventory Turnover measures the firms inventory management efficiency Accounts Receivable Turnover measures the firms cash management efficiency

Working Investment is the amount that should be financed from outside the operating cycle (it is directly related to sales) Credit Risk refers to the ability and willingness of a borrower to pay its debts ( Ability: is determined by the capacity to generate cash from operations & Willingness: depends on which competing cash need is viewed as the most pressing at the moment Statement of Cash Flow is an important source of information to analyze a companys credit risk Liquidity is a firms ability to meet its current maturing obligations from available cash or near cash resources (ability to generate cash from internal operations) for assets ( describes how quickly an asset can be converted into cash and the certainty associated with the conversion ratio or price

for liabilities ( describes how quickly obligations will have to be paid in cash and whether or not these obligations can be paid at less than their full repayment amount

Solvency is a firms ability to meet all its maturing obligations as they come due (either from internal or external sources) without losing the ability to continue operations Current Assets are those assets that are likely converted to cash within one year or less Long-term Assets are those assets that are less liquid than current assets (some maybe very illiquid)

Current Liabilities are those liabilities that must be paid within one year

Long-term Liabilities are those liabilities that can become immediately due & payable if the company violates contractual debt covenants or other obligations Working Capital represents a cushion or margin of protection for current creditors its analysis is directly related to Working Investment analysis (special consideration should be given to the quality of current assets especially accounts receivable & inventory)Important Notes

Investment in Fixed Assets (e.g. plant, machinery, land, building) is recovered after many years of the companys operations

Investment in Current Assets (e.g. inventory, A/R) is recovered during the companys operating cycle (which is normally within one calendar year) Cash ( Inventory & Labor ( Product ( Cash (again) Elements of Working Capital are:1. Cash

2. A/R

3. Inventory

Short-term in nature4. A/P

5. Accruals

Elements of Trading Assets are:

6. Inventory

7. A/R

8. Advance Payments

Elements of Spontaneous Financing are:

9. A/P

10. Accrued Expenses

11. Down Payment

During a period of Rising Prices, it is better to evaluate Inventory using LIFO (for Income Statement reporting), as it provides a better indication for Current Income & Future Profitability Accounts Receivable need to be at a low level in order to reduce the firms costs and exposure to bad debts

Accounts Receivable the main considerations are: Credit Policy (using credit report, customers financial statements, bank references & reputation among other vendors), Terms of Sale and Collections Policy (adequate provisions) Operating Leverage total variable costs vary with sales ~ fixed costs do not vary with sales as they remain constant regardless of how much the company produces or sells (e.g. rent, depreciation) An increase in Financial Leverage results in an increase in Return on Equity. Higher Financial Leverage results in higher Interest Rate on the companys Debt Investment Activities the classification of Investment depends on the degree of influence or control the investor has Less than 20% ( No Significant Control [Trading]

20% - 50% ( Significant Control [Equity Method]

More than 50% ( Control [Consolidation] Accounting for Investment Income:1. Cost Method recognizes price changes only when the securities are sold2. Market Method mirrors the actual market value of the securities and recognizes price changes whenever they occur

3. Lower of Cost or Market Method (LoCoM) recognizes price changes prior to sale of securities ONLY when market value is less than book value (original cost of securities)MethodBalance Sheet ReportingIncome Statement Reporting

CostPurchase Value (Cost)Dividends Received

Realized Gain or Loss

MarketMarket ValueDividends Received

Realized & Unrealized Gain or Loss

LoCoMPurchase or Market Value (whichever is lower)Dividends Received

Realized Gain or Loss

Unrealized Loss or Recovery

Dividends are accounted for as part of income earned of the reported accounting period Types of Securities:

Traded ( Cost Method

Held for Trading

Available for Sale ( Market Method Balance Sheet( Cost Method Income Statement / Unrealized Gain or Loss is reported separately in Shareholders Equity Held to Maturity

TypeBalance Sheet ReportingIncome Statement Reporting

Held for TradingMarket MethodDividends Received

Realized Gain or Loss

Unrealized Loss or Recovery

Available for SaleMarket Method

Unrealized Gain or Loss in Shareholders EquityDividends Received

Realized Gain or Loss

Held to MaturityCost MethodDividends Received

Realized Gain or Loss

Illustrative Diagram

Held for Trading

Profits could be manipulated through reclassification Unrealized Gain/Loss reduce earnings quality

Unrealized Gain/Loss should be eliminated when calculating Profitability Ratios

Unrealized Gain/Loss maybe considered when calculating Leverage & Capital Structure Ratios

Equity Method of Accounting is used when the investor exercises a significant control over the investment the investor reports the proportionate share in the investments net assets and recognizes the proportionate share of its income ~ Gains & Losses are recognized only when realized dividends received reduce the carrying value of the investment changes in the market value of the investment are not recognized under this method unless there is a permanent impairment

favorable results are reported in case the investment is a profitable one as long as dividend payout is less than 100% interest coverage ratio & return ratios will improve the investor recognizes the proportionate share in investment income without any recognition of its debt; therefore, leverage ratios improve if the investment profitability declines while assets and equity increase, the investors return ratios may be adversely affected; therefore, equity earning must be adjusted by including actual dividends received in the income of the investor Consolidation Minority Interest equals the proportionate share of the minority in the equity of the subsidiary less dividends paid Minority Interest should be considered as a long term liability when calculating leverage ratios Interest Expense Interest Rate = Interest Expense / Average Funded Debt changes in Interest Rate to Average Funded Debt indicate either changes in the type of debt or average interest rate charges in case that the interest rate indicated by this ratio is unreasonably high compared to the prevailing interest rates, this implies that the company is using short term financing that was paid (cleared) before the financial statements dates it is usually used as a measure of the companys ability to cover its interest payments {Time Interest Earned = EBITDA / Interest Expense}

Credit Risk Analysis using financial ratios involves an assessment of liquidity and solvency

Liquidity is mainly related to the analysis of the companys Working Investment (i.e. Operating Cycle) Liquidity each asset & liability on the companys balance should be evaluated for liquidity Liquidity Measures include: Working Capital = Current Assets Current Liabilities

Current Ratio = Current Assets / Current Liabilities

Quick Ratio = (Cash + Marketable Securities + A/R) / Current Liabilities)

The improvement is Asset Efficiency Ratios may indirectly indicate that the company is becoming more liquid over time Solvency the aim of long-tem solvency analysis is to detect early signs of heading to financial difficulties (i.e. decline in profitability & liquidity ratios, unfavorable debt to equity ratio and unfavorable interest coverage ratio) Debt Ratios are useful for understanding the financial structure of the company; however, they provide no information about the companys ability to generate a stream of inflows that is sufficient to make principal & interest payments Interest Coverage Ratio is commonly used to cover for the shortcoming of the debt ratios /\ it is a measure of creditors protection from default on interest payments

FormulasWorking Investment= Trading Assets Spontaneous Financing

Working Capital

= Current Assets Current Liabilities

by ignoring Cash & all Non-Operating Assets & Liabilities (Working Capital

= Trading Assets Spontaneous Financing STD

= Working Investment STD

Ending Inventory

= Beginning Inventory + Purchases + CoGS

Breakeven Point ( Quantity Sold= Total Variable Cost + Fixed Cost

Total Return Earned on Investment= Dividends Received + Capital Gain (Loss)Leverage

= Total Liabilities / Total Tangible Net WorthRatios

Inventory Turnover= (Average) CoGS / (Average) Inventorythe higher the better

Inventory Days on Hand (DoH)= 365 / Inventory Turnover

the lower the better

A/R Turnover

= (Average) CoGS / (Average) A/Rthe higher the better

A/R DoH

= 365 / A/R Turnoverthe lower the better

A/P Turnover

= CoGS / (Average) A/P A/P DoH

= 365 / A/P Turnover Accrued Expenses Turnover= CoGS / Accrued Expenses Accrued Expenses DoH

= 365 / Accrued Expenses Turnover Working Investment / Salesthe lower the better

Sales / Average Net Plant

( used for capital intensive industries only Interest Rate

= Interest Expense / Average Funded Debt( gives a rough indication of the interest rate the firm is paying Current Ratio

= Current Assets / Current Liabilities

( the analysis of this ratio should consider the quality of the assets especially accounts receivable & inventory

( Current Ratio > 1, an equal increase in both current assets & current liabilities will decrease the ratio

( Current Ratio < 1, an equal increase in both current assets & current liabilities will increase the ratio

( is subject to window dressing e.g. repayment of all revolving credit lines just before the close of the financial statements (thus, improving the ratio)( its disadvantage is that it uses year-end balances of current assets and current liabilities Current Cash Debt Coverage Ratio= Cash Flow from Operations / Average Current Liabilities

( is used rather than the Current Ratio as it considers the entire year rather than one point

( is considered a better representation of liquidity Quick Ratio

= (Cash + Marketable Securities + A/R) / Current Liabilities)

( eliminates Inventory providing a more short-term reflection of liquidity (since few businesses can instantaneously convert inventory into cash) Inventory Reliance Ratio

= [Current Liabilities (Cash + Marketable Securities + A/R)] / Inventory

( indicates the minimum percentage of inventory that must be converted into cash to payout current creditors after cash, marketable securities & A/R have been liquidated

( assumes full collection of A/R and sale of marketable securities at book value Debt to Equity Ratio

= Total Debt / Total Tangible Net Worth( gives some idea about how risky the company might be

(is low for retailers & high for heavy industries Cash Debt Coverage Ratio= Cash Flow from Operations / Average Total Liabilities

( is a measure of solvency using cash figures

( it shows the ability of a company to generate cash from operations in order to service both short & long-term borrowings Times Interest Earned

= EBITDA / Interest Expense

Interest Coverage Ratio

= (Income before Taxes + Interest Expense) / Interest ExpenseCapital Structure Capital Mix is a tradeoff between Cost & Risk Debt & Equity

Typically, Debt has a lower cost than Equity even though its incremental cost will increase as its amount increases in capital structure

Debt requires contractual repayments of Principal & Interest failure to meet them means default and results in penalties and sometimes loss of property and assets to creditors

has priority over common dividend payments

Equity does not require contractual payments to equity holders

in case there is no availability of cash to pay dividends, in case of common stock, shareholders cannot force bankruptcy equity holders expect to earn higher return in order to accept the uncertainty of dividend payments and future value of their investment Generally, the higher the percentage of Equity, the higher the companys rating and the easier the access to capital markets & the higher the absolute after-tax cost of capital to the company On the contrary, the higher the percentage of Debt (assuming it stays within a reasonable range), the lower the after-tax cost of capital to the company The appropriate level of Debt in the Capital Structure is a function of the companys cash flow tenor matching & its ability to pay interest costs associated with this debt in addition to business risk In general, the more consistent & predictable the companys cash flow, the more debt it can support Two criteria govern the appropriateness of a companys capital structure:

Tenor Matching ( financing tenor should match the tenor of assets financed (i.e. short term finance for short term need and long term finance for long term needs) Short Term Financing: is required to finance a temporary shortage in cash within the companys operating cycle (i.e. a mismatch between Trading Assets DoH & Spontaneous Financing DoH); it is also required to finance seasonal peaks in the companys operating cycle (when analyzing short term financing, special consideration should be given to the business risk associated with the companys operating cycle as well as the permanent investment in assets) Business Risk ( should be absorbed by equity holders Permanent Level of Working Investment should be financed by Equity and/or Long term DebtIllustrative Diagram

Trading

Held to Maturity

Available for Sale

Cost Method

Yes

No

Consolidation

Equity Method

20%-50%

< 20%

> 50%

Investment

Full Control

Significant Control

No Significant Control

Traded

Company

Short term Investment

Long term Investment

Working Investment

Long term Assets

Short term Debt

Permanent Fund

Short term Debt Revolving

Long term Debt

Equity

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