ch 10 - credit analysis

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Chapter 10 - Credit Analysis

Chapter 10

Credit Analysis

REVIEW

This chapter focuses on credit analysis. It is separated into two major sections li!uidityanalysis and sol"ency analysis. #i!uidity refers to the a"aila$ility of resources to meetshort%term cash re!uirements. A company&s short%term li!uidity ris' is affected $y thetimin( of cash inflows and outflows alon( with its prospects for future performance. )ur analysis of li!uidity is aimed at companies& operatin( acti"ities* their a$ility to (enerate

profits from the sale of (oods and ser"ices* and wor'in( capital re!uirements andmeasures. This chapter descri$es se"eral financial statement analysis tools to assessshort%term li!uidity ris' for a company. We $e(in with a discussion of the importance of li!uidity and its lin' to wor'in( capital. We e+plain and interpret useful ratios of $othwor'in( capital and a company&s operatin( cycle for assessin( li!uidity. We also discusspotential adjustments to these analysis tools and the underlyin( financial statementnum$ers. What%if analysis of chan(es in a company&s conditions or strate(ies concludesthis section.

The second part of this chapter considers sol"ency analysis. ,ol"ency is an importantfactor in our analysis of a company&s financial statements. ,ol"ency refers to acompany&s lon(%run financial "ia$ility and its a$ility to co"er lon(%term o$li(ations. All

$usiness acti"ities of a company-financin(* in"estin(* and operatin(-affect acompany&s sol"ency. )ne of the most important components of sol"ency analysis is thecomposition of a company&s capital structure. Capital structure refers to a company&ssources of financin( and its economic attri$utes. This chapter descri$es capitalstructure and e+plains its importance to sol"ency analysis. ,ince sol"ency depends onsuccess in operatin( acti"ities* the chapter e+amines earnin(s and its a$ility to cover important and necessary company e+penditures. ,pecifically* this chapter descri$es"arious tools of sol"ency analysis* includin( le"era(e measures* analytical accountin(adjustments* capital structure analysis* and earnin(s%co"era(e measures. Wedemonstrate these analysis tools with data from financial statements. We also discussthe relation $etween ris' and return inherent in a company&s capital structure* and itsimplications for financial statement analysis.

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,ection 1 #i!uidity

• #i!uidity and Wor'in( Capital

Current Assets and #ia$ilities

Wor'in( Capital easure of #i!uidity

Current Ratio easure of #i!uidity

sin( the Current Ratio for Analysis

Cash%ased Ratio easures of #i!uidity

• )peratin( Acti"ity Analysis of #i!uidity

Accounts Recei"a$le #i!uidity easures

In"entory Turno"er easures

#i!uidity of Current #ia$ilities

• Additional #i!uidity easures

Current Assets Composition

Acid%Test 23uic'4 Ratio

Cash 5low easures

5inancial 5le+i$ility

ana(ement&s 6iscussion and Analysis

• What%If Analysis

,ection 7 Capital ,tructure and ,ol"ency

• Importance of Capital ,tructure

Characteristics of 6e$t and E!uity

oti"ation for 6e$t Capital

Concepts of 5inancial #e"era(e

Adjustments for Capital ,tructure Analysis

• Capital ,tructure Composition and ,ol"ency

Common%,i8e ,tatements in ,ol"ency Analysis

Capital ,tructure easures for ,ol"ency Analysis

Interpretation of Capital ,tructure easures

Asset%ased easures of ,ol"ency

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• Earnin(s Co"era(e

Relation of Earnin(s to 5i+ed Char(es

Times Interest Earned Analysis

Relation of Cash 5low to 5i+ed Char(es

Earnin(s Co"era(e of 9referred 6i"idendsInterpretin( Earnin(s Co"era(e easures

• Capital ,tructure Ris' and Return

Appendi+ 11A Ratin( 6e$t

Appendi+ 11 9redictin( 5inancial 6istress

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A/A#:,I, );ECTIVE,

• E+plain the importance of li!uidity in analy8in( $usiness acti"ities.

• 6escri$e wor'in( capital measures of li!uidity and their components.

• Interpret the current ratio and cash%$ased measures of li!uidity.

• Analy8e operatin( cycle and turno"er measures of li!uidity and their interpretation.

• Illustrate what%if analysis for e"aluatin( chan(es in company conditions andpolicies.

• 6escri$e capital structure and its relation to sol"ency.

• E+plain financial le"era(e and its implications for company performance andanalysis.

• Analy8e adjustments to accountin( $oo' "alues to assess capital structure.

• 6escri$e analysis tools for e"aluatin( and interpretin( capital structurecomposition and for assessin( sol"ency.

• Analy8e asset composition and co"era(e for sol"ency analysis.

• E+plain earnin(s%co"era(e analysis and its rele"ance in e"aluatin( sol"ency.

• 6escri$e capital structure ris' and return and its rele"ance to financial statementanalysis.

• Interpret ratin(s of or(ani8ations& de$t o$li(ations 2Appendi+ 11A4.

• 6escri$e prediction models of financial distress 2Appendi+ 114.

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1. #i!uidity is an indicator of an entity&s a$ility to meet its current o$li(ations. An entityin a wea' short%term li!uidity position will ha"e difficulty in meetin( short%termo$li(ations. This has implications for any current and potential sta'eholders of a

company. 5or e+ample* lac' of li!uidity would affect users< analysis of financialstatements in the followin( waysEquity investor In this case* the company li'ely is una$le to a"ail itself of fa"ora$lediscounts and to ta'e ad"anta(e of profita$le $usiness opportunities. It could e"enmean loss of control and e"entual partial or total loss of capital in"estment.Creditors In this case* delay in collection of interest and principal due would $ee+pected and there is a possi$ility of the partial or total loss of the amounts duethem.

7. A major limitation in usin( wor'in( capital 2in dollars4 as an analysis measure is itsfailure to meanin(fully relate it to other measure for interpreti"e purposes. That is*wor'in( capital is much more meanin(ful when related to other amounts* such as

current lia$ilities or total assets. In addition* the importance attached to wor'in(capital $y "arious users pro"ides a stron( incenti"e for an entity 2especially the onesin a wea' financial position4 to stretch the definition of its components. 5or e+ample*some mana(ers may =e+pand> the definition of what constitutes a current asset anda current lia$ility to $etter present their current position in the most fa"ora$le li(ht.oreo"er* there are se"eral opportunities for mana(ers to stretch these definitions.5or this reason* the analyst must use jud(ment in e"aluatin( mana(ement rule4. In the case of fi+ed assets* there is the possi$ilityof their inclusion in current assets under one condition. The condition is thatmana(ement intends to sell these fi+ed assets and mana(ement has a definitecontractual commitment from a $uyer to purchase them at a specific price within thefollowin( year 2or operatin( cycle* if lon(er4.

@. Installment recei"a$les deri"ed from sales in the re(ular course of $usiness aredeemed to $e collecti$le within the operatin( cycle of a company. Therefore* suchinstallment recei"a$les are to $e included in current assets.

. In"entories are not always reported as current assets. ,pecifically* in"entory amountsin e+cess of current re!uirements should $e e+cluded from current assets. Currentre!uirements include !uantities to $e used within one%year or the normal operatin(

cycle* whiche"er period is lon(er. usiness at times $uilds up its in"entory in e+cessof current re!uirement to hed(e a(ainst an increase in price or in anticipation of astri'e. ,uch e+cess in"entories $eyond the re!uirements of one year should $eclassified as noncurrent.

B. 9repaid e+penses represent ad"ance payments for ser"ices and supplies that wouldotherwise re!uire the current outlay of funds durin( the succeedin( one%year or alon(er operatin( cycle.

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. an's usually reser"e the ri(ht not to renew the whole or part of a loan at their optionwhen they si(n a re"ol"in( loan a(reement. The fact that a $an' a(rees informally torenew short%term notes does not ma'e them noncurrent. The possi$ility that thecompany under analysis included such notes under lon(%term lia$ilities should $ecarefully assessed 2and potentially reclassified if our analysis su((ests otherwise4.

D. ,ome of these industry characteristics* such as the a$sence of any distinction$etween current and noncurrent on the $alance sheet in the real estate industry* canindeed re!uire special treatment. owe"er* e"en in such cases* analysts should $ecareful to consider whether these FspecialF characteristics chan(e the relatione+istin( $etween current o$li(ations and the li!uid funds a"aila$le 2or reasona$lye+pected to $ecome a"aila$le4 to meet them. )ur analysis should adjust theclassifications of any items not meetin( our assessment of the current andnoncurrent criteria.

G. Identical wor'in( capital does not imply identical li!uidity. The a$solute amount of wor'in( capital has si(nificance only when related to other "aria$les such as sales*total assets* etc. The a$solute amount only has* at $est* a limited "alue for intercompany comparisons. A $etter (au(e of li!uidity when focusin( on wor'in(

capital is to relate its amount to either or $oth of current assets and current lia$ilities2or sales* assets* etc.4.

10. The current ratio is the ratio of current assets to current lia$ilities. It is a staticmeasure of resources a"aila$le at a (i"en point in time to meet current o$li(ations.The reasons for its widespread use include

• It measures the de(ree to which current assets co"er current lia$ilities.

• It measures the mar(in of safety a"aila$le to allow for possi$le shrin'a(e in the"alue of current assets.

• It measures the mar(in of safety a"aila$le to meet the uncertainties and the randomshoc's to which the flows of funds in a company are su$ject.

11. Cash inflows and cash outflows are not perfectly predicta$le. 5or e+ample* in thecase of a $usiness downturn* sales can decline more rapidly than do outlays for purchases and e+penses. The amount of cash held is in the nature of a precautionaryreser"e* which is intended to ta'e care of short%term surprises in cash inflows andoutflows.

17. There is a relation $etween in"entories and sales. ,pecifically* as sales increase2decrease4* the in"entory le"el typically increases 2decreases4. owe"er* in"entoriesare a direct function of sales only in rare cases. ethods of in"entory mana(emente+ist* and e+perience su((ests that in"entory increments "ary not in proportion todemand 2sales4 $ut rather with measure appro+imatin( the s!uare root of demand.

1?. ana(ement


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• There is no direct or esta$lished relationship $etween $alances of wor'in( capitalitems and the pattern which future cash flows are li'ely to assume.

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• ana(erial policies directed at optimi8in( the le"els of recei"a$les and in"entoriesare oriented primarily toward the efficient and profita$le utili8ation of assets andonly secondarily at li!uidity considerations.

1. The limitations to which the current ratio is su$ject should $e reco(ni8ed and its useshould $e restricted to the type of analytical tas' it is capa$le of ser"in(. ,pecifically*

the current ratio can help assess the ade!uacy of current assets to dischar(e currentlia$ilities. This implies that any e+cess 2called wor'in( capital4 is a li!uid surplusa"aila$le to meet im$alances in the flow of funds* shrin'a(e in "alue* and other contin(encies.

1B. Cash%$ased ratios of li!uidity typically refer to the ratio of cash 2includin( cashe!ui"alents4 to total current assets or to total current lia$ilities. The choice of deflator depends on the purposes of analysis. 2i4 The hi(her the ratio of cash to total currentassets the more li!uid the current asset (roup is. This means that this portion of thetotal current assets is su$ject only to a minimal dan(er of loss in "alue in case of li!uidation and that there is practically no waitin( period for con"ersion of theseassets into usa$le cash. 2ii4 The ratio of cash to total current lia$ilities measures howmuch cash and cash e!ui"alents are a"aila$le to immediately pay current o$li(ations.This is a se"ere test that i(nores the re"ol"in( nature of current lia$ilities. Itsupplements the cash ratio to total current assets in that it measures cash a"aila$ilityfrom a somewhat different point of "iew.

1. An important measure of the !uality of current assets such as recei"a$les andin"entories is their turno"er. The faster the turno"er-collections in case of recei"a$les and sales in case of in"entories-the smaller the li'elihood of loss onultimate reali8ation of these assets.

1D. The a"era(e accounts recei"a$le turno"er measures in effect the speed of their collection durin( the period. The hi(her the turno"er fi(ure* the faster the collectionsare* on a"era(e.

1G. The collection period 2or days& sales in accounts recei"a$le4 measures the num$er of days& sales uncollected. It can $e compared to a company&s credit terms to e"aluatethe !uality of its collection acti"ities.

70. Either one or all of the followin( are possi$le reasons for an increase in the collectionperiod• A relati"ely poorer collection jo$.

• 6ifficulty in o$tainin( prompt payment for "arious reasons from customers in spiteof dili(ent collection efforts.

• Customers in financial difficulty* which in turn may imply a poor jo$ $y the creditdepartment.

• Chan(e of credit policies or sales terms in a desire to increase sales.

• E+cessi"e delin!uency of one or a few su$stantial customers.

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71. 2a4 If the in"entory le"el is inade!uate* the sales "olume may decline to $elow thele"el of sales otherwise attaina$le. A loss of potential customers can also occur. 2$4E+cessi"e in"entories* howe"er* e+pose the company to e+penses such as stora(ecosts* insurance* and ta+es as well as to ris's of loss of "alue throu(h o$solescenceand physical deterioration. E+cessi"e in"entories also tie up funds that can $e usedmore profita$ly elsewhere.

77. The #I5) method of in"entory "aluation in times of increasin( costs can render $oththe in"entory turno"er ratio as well as the current ratio practically meanin(less.owe"er* there is information re(ardin( the #I5) reser"e that is reported in financialstatements. se of the #I5) reser"e ena$les the analyst to adjust an unrealisticallylow #I5) in"entory "alue to a more meanin(ful in"entory amount. ,till* inintercompany comparati"e analysis* e"en if two companies use #I5) cost methodsfor their in"entory "aluations* the ratios $ased on such in"entory fi(ures may not $ecompara$le $ecause their respecti"e #I5) in"entory pools 2$ases4 may ha"e $eenac!uired in years of si(nificantly different price le"els.

7?. The composition of current lia$ilities is important $ecause not all current lia$ilitiesrepresent e!ually ur(ent and forceful calls for payment. ,ome claims* such as for

ta+es and wa(es* must $e paid promptly re(ardless of current financial difficulties.)thers* such as trade $ills and loans* usually do not represent e!ually ur(ent calls for payment.

7@. Chan(es in the current ratio o"er time do not automatically imply chan(es in li!uidityor operatin( results. In a prosperous year* (rowin( lia$ilities for ta+es can result in alowerin( of the current ratio. oreo"er* in times of $usiness e+pansion* wor'in(capital re!uirements can increase with a resultin( contraction of the current ratio-so%called Fprosperity s!uee8e.F Con"ersely* durin( a $usiness contraction* currentlia$ilities may $e paid off while there is a concurrent 2in"oluntary4 accumulation of in"entories and uncollected recei"a$les causin( the ratio to rise. 5inally* ad"ances inin"entory practices 2such as just%in%time4 can lower the current ratio.

7. FWindow dressin(F refers to the adjustment of year%end account $alances of currentassets and lia$ilities to show a more fa"ora$le current ratio than is otherwisewarranted. This can $e accomplished* for e+ample* $y temporarily steppin( up theefforts for collection* $y temporarily recallin( ad"ances and loans to officers* and $yreducin( in"entory to $elow the normal le"el and use the proceeds from these stepsto pay off current lia$ilities. The analyst should (o $eyond year%end reportedamounts and try to o$tain as many interim readin(s of the current ratio as possi$le.E"en if the year%end current ratio is "ery stron(* interim ratios may re"eal that thecompany is dan(erously close to insol"ency. ore (enerally* our analysis mustalways $e aware of the possi$ility of window dressin( of $oth current and noncurrentaccounts.

7B. The rule of thum$ re(ardin( the current ratio is 71 - a "alue $elow that le"elsu((ests serious li!uidity ris'. Also* the rule of thum$ su((ests that the hi(her thecurrent ratio $e a$o"e the 71 le"el* the $etter. The followin( points* howe"er* should$e 'ept in mind so as not to e+pose our analysis to undue ris's of errors ininferences

• A current ratio much hi(her than 7 to 1* while implyin( a superior co"era(e of current lia$ilities* can si(nal a wasteful accumulation of li!uid resources.

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• It is the !uality of the current assets and the nature of the current lia$ilities that aremore si(nificant in interpretin( the current ratio-not simply the le"el itself.

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• The need of a company for wor'in( capital "aries with industry conditions as wellas with the len(th of its own net trade cycle.

7. In an assessment of the o"erall li!uidity of a company


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?1. Analysis of capital structure is important $ecause the financial sta$ility of a companyand the ris' of insol"ency depend on the financin( sources as well as on the type of assets it holds and the relati"e ma(nitude of such asset cate(ories. ,pecifically* thereare essential differences $etween de$t and e!uity* which are the two major sources of funds. E!uity capital has no (uaranteed return that must $e paid out and there is notimeta$le for repayment of the capital in"estment. 5rom the "iewpoint of a company*e!uity capital is permanent and can $e counted on to remain in"ested e"en in timesof ad"ersity. Therefore* the company can confidently in"est e!uity funds in lon(%termassets and e+pose them to the (reatest ris's. )n the other hand* de$ts are e+pectedto $e paid at certain specified times re(ardless of a company&s financial condition. Tothe in"estor in common stoc'* the e+istence of de$t contains a ris' of loss of in"estment. The creditors would want as lar(e a capital $ase as is possi$le as acushion that will shield them a(ainst losses that can result from ad"ersity. Therefore*it is important for the financial analyst to re"iew carefully all the elements of thecapital structure.

?7. 5inancial le"era(e is the result of $orrowin( and incurrin( fi+ed o$li(ations for interest and principal payments. The owners of a successful $usiness that re!uires

funds may not want to dilute their ownership of the $usiness $y issuin( additionale!uity. Instead* they can Ftrade on the e!uityF $y $orrowin( the funds re!uired* usin(their e!uity capital as a $orrowin( $ase. 5inancial le"era(e is ad"anta(eous when therate of return on total assets e+ceeds the net after%ta+ interest cost paid on de$t. Anadditional ad"anta(e pro"ided $y financial le"era(e is that interest e+pense is ta+deducti$le while di"idend payments are not.

??. #e"era(e is a two%ed(ed sword. In (ood times* net income $enefit from le"era(e. In arecession or when une+pected ad"erse e"ents occur* net income can $e harmed $yle"era(e. Therefore* the use of le"era(e is accepta$le to the financial mar'ets only upto some undefined le"el. /inety percent is hi(her than that =accepta$le> le"el.,pecifically* at G0 percent de$t to total capital* future financin( fle+i$ility would $e

e+tremely limited* lenders would not loan money* and e!uity financin( may cost morethan the potential returns on incremental in"estments. Also* a G0 percent de$t le"elwould ma'e net earnin(s e+tremely "olatile* with a si8a$le increase in fi+ed char(es.The incremental cost of $orrowin(* includin( refundin( of maturin( issues* increaseswith the le"el of $orrowin(. A G0 percent de$t le"el could pose the pro$a$ility of default and recei"ership in the e"ent that somethin( (oes wron(. The financial ris' of such a company would $e much too hi(h for either stoc'holders or $ondholders.

?@. In an analysis of deferred income ta+es* the analyst must reco(ni8e that under normalcircumstances the deferred ta+ lia$ilities will =re"erse> 2$ecome paya$le4 only when afirm shrin's in si8e. ,hrin'a(e in firm si8e is usually accompanied with losses insteadof with ta+a$le income. In such circumstances* the =drawin( down> of the deferred

ta+ account is more li'ely to in"ol"e credits to ta+ loss carryforwards or carry$ac's*rather than to the cash account. To the e+tent that a future re"ersal is only a remotepossi$ility* the deferred credit should $e "iewed as a source of lon(%term fundin( and$e classifia$le as part of e!uity. )n the other hand* if the possi$ility of a drawin(down of the deferred ta+ account in the foreseea$le future is hi(h* then the account*or a portion of it* is more in the nature of a lon(%term lia$ility.

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?. The accountin( re!uirements for the capitali8ation of leases are not ri(orous anddefinite enou(h to insure that all leases that represent* in effect* installmentpurchases of assets are capitali8ed. Conse!uently* the analyst must e"aluate leasesthat ha"e not $een capitali8ed with a "iew to includin( them amon( de$t o$li(ations.#eases which co"er most 2say %D0 percent4 of the useful life of an asset can(enerally $e considered the e!ui"alent of de$t financin(. 2,ee Chapter ? for additional analysis and discussion.4

?B. )ff%$alance%sheet financin( are attempts $y mana(ement to structure transactions insuch a way as to e+clude de$t 2and related assets4 from the $alance sheet. This isusually accomplished $y emphasi8in( le(al 2accountin(4 form o"er su$stance.E+amples of such transactions are ta'e or pay contracts* certain sales of recei"a$les*and in"entory repurchase a(reements.

?. 9ension accountin( reco(ni8es that if the fair "alue of pension assets falls short of the accumulated pension $enefit o$li(ation* a lia$ility for pensions e+ists. owe"er*this lia$ility normally does not ta'e into consideration the projected $enefit o$li(ationthat reco(ni8es an estimate for future pay increases. When pension plans $ase their $enefits on future pay formulas* the analysts* who jud(e such understatement as

serious and who can estimate it* may want to adjust the pension lia$ility for analysispurposes.

?D. The preferred method of presentin( the financial statements of a parent and itssu$sidiary is in consolidated format. This is also the preferred method from ananalysis point of "iew. owe"er* separate financial statements of the consolidatedentities are necessary in some cases* such as when the utili8ation of assets of asu$sidiary 2such as an insurance company or a $an'4 is not su$ject to the fulldiscretion of the parent. Information on unconsolidated su$sidiaries is also importantwhen $ondholders of such su$sidiaries must loo' only to a su$sidiary


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li'ely to $e con"erted into common stoc'* it should $e considered as e!uity for the purpose of capital structure analysis.

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e. ost preferred stoc' entails no a$solute o$li(ation for payment of di"idends or repayment of principal-that is* it possesses characteristics of e!uity. owe"er*preferred stoc' with a fi+ed maturity or su$ject to sin'in( fund re!uirementsshould* from an analysis point of "iew* $e considered as de$t.

@0. a. The e!uity of a company is measured $y the e+cess of total assets o"er totallia$ilities. Accordin(ly* any analytical re"ision of asset $oo' "alues 2from amountsreported at in the financial statements4 yields a chan(e in the amount of e!uity.5or this reason* in assessin( capital structure* the analyst must decide whether or not the $oo' "alue amounts of assets are realistically stated in li(ht of analysiso$jecti"es.

$. The followin( are e+amples of the need for possi$le adjustments. 6ifferent or additional adjustments may $e needed dependin( on circumstances 214In"entories carried at #I5) are (enerally understated in times of risin( prices. Theamount $y which in"entories computed under 5I5) 2which are closer toreplacement cost4 e+ceed in"entories computed under #I5) is disclosed as the#I5) reser"e. These disclosures should ena$le the analyst to adjust in"entoryamounts and the correspondin( e!uity amounts to more realistic current costs.

274 5or fiscal years $e(innin( $efore 17H1BHG?* mar'eta$le securities were(enerally stated at cost* which may $e $elow mar'et "alue. sin( parenthetical or footnote information* the analyst can ma'e an analytical adjustment increasin(this asset to mar'et "alue and increasin( owner&s e!uity $y an e!ual amount. 2?4Intan(i$le assets and deferred items of du$ious "alue* which are included on theasset side of the $alance sheet* ha"e an effect on the computation of the totale!uity of a company. To the e+tent that the analyst cannot e"aluate or form anopinion on the present "alue or future utility of such assets* they may $e e+cludedfrom consideration* there$y reducin( the amount of e!uity $y the amounts atwhich such assets are carried. owe"er* the ar$itrary e+clusion of all intan(i$leassets from the capital $ase is an unjustified e+ercise in o"er%conser"atism.

@1. #on(%term creditors are interested in the future operations and cash flows of a de$tor 2in addition to the short%term financial condition of the de$tor4. 5or e+ample* acreditor of a three%year loan would want to ma'e an analysis of sol"ency assumin(the worst set of economic and operatin( conditions. 5or such purposes* an analysisof short%term li!uidity is usually not ade!uate. owe"er* such a dynamic analysis for the lon( term is su$ject to su$stantial uncertainties and re!uires assumptions for amuch lon(er time hori8on. The ine"ita$le lac' of detail and the uncertainties inherentin lon(%term projections se"erely limit their relia$ility. This does not mean thatlon(%term projections are not useful. What it does mean is that the analyst must $eaware of the serious limitations to which they are su$ject.

@7. Common%si8e analysis focuses on the composition of the funds that finance a

company. As such* it reflects on the financial ris' inherent in the capital structure.,pecifically* it shows the relati"e ma(nitudes of the financin( sources of the companyand allows the analyst to compare them with similar data of other companies. Instead*capital structure ratios reflect on the financial ris' of a company $y relatin( "ariouscomponents of the capital structure to each other or to total financin(. An ad"anta(eof ratio analysis is that it can $e used as a screenin( de"ice and* moreo"er* canreflect on relations across more than one financial statement.

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@?. The difference $etween the $oo' "alue of e!uity capital and its mar'et "alue isusually due to a num$er of factors. )ne of these is the effect of price%le"el chan(es.These* in turn* are caused $y at least two factors chan(e in the purchasin( power of money and chan(e in price due to economic factors such as the law of supply anddemand. Therefore* with fluctuatin( prices* it is unli'ely that historical cost willcorrespond to mar'et "alue. Accountin( methods in use can also si(nificantly affectthe $oo' "alues of assets. 5or e+ample* a particular depreciation method often isadopted for ta+ reasons rather than to measure the loss of "alue of an asset due touse or o$solescence. The analyst could potentially adjust for this distortion of current"alue $y "aluin( the e!uity at mar'et "alue. 5or acti"ely traded securities this wouldnot $e too difficult. owe"er* the stoc' mar'et too is often su$ject to su$stantialo"er"aluation and under"aluation dependin( on the de(ree of speculati"e sentiment.ence* in most cases* e!uity capital will not $e adjusted to mar'et-instead* thefocus will $e on "aluin( assets and lia$ilities* with e!uity as a residual "alue.

@@. ,ince lia$ilities and e!uity re"eal the financin( sources of a company* and the assetside re"eals the in"estment of these funds* we can (enerally esta$lish direct relations$etween asset (roups and selected items of capital structure. This does not* of course* imply that resources pro"ided $y certain lia$ilities or e!uity should $e directly

associated with the ac!uisition of certain assets. ,till* it is "alid to assume that thetypes of assets a company employs should determine to some e+tent the sources of resources used to finance them. Therefore* to help assess the ris' e+posure of a(i"en capital structure* the analysis of asset distri$ution is one important dimension.As an e+ample* if a company ac!uired lon(%term assets $y means of short%term$orrowin(s* the analyst would conclude that this particular method of financin(in"ol"es a considera$le de(ree of ris' 2and cost4.

@. The earnin(s to fi+ed char(es ratio measures directly the relation $etweende$t%related and other fi+ed char(es and the earnin(s a"aila$le to meet thesechar(es. It is an e"aluation of the a$ility of a company to meet its fi+ed char(es out of current earnin(s. Earnin(s co"era(e ratios are superior to other tools* such as de$t%

to%e!uity ratios* which do not focus on the a"aila$ility of funds. This is $ecauseearnin(s co"era(e ratios directly measure the a"aila$ility of funds for payment of fi+ed char(es. 5i+ed char(es are mainly a direct result of the incurrence of de$t. Anina$ility to pay their associated principal and interest payments represents the mostserious ris' conse!uence of de$t.

@B. Identifyin( the items to include in Ffi+ed char(esF depends on the purpose of theanalysis. 5i+ed char(es can $e defined narrowly to include only interest and intereste!ui"alents or $roadly to include all outlays re!uired under contractual o$li(ations-specifically2a4 Interest and interest e!ui"alents

i. Interest on lon(%term de$t 2includin( amorti8ation of any discounts and

premiums4.ii. Interest element included in lon(%term lease rentals.iii. Capitali8ed interest.

2$4 )ther outlays under contractual o$li(ationsi. Interest on income $onds 2assumin( profita$le operations-implicit

assumption in such $orrowin(s4.ii. Re!uired deposits to sin'in( funds and principal payments under serial $ond

o$li(ations.iii. 9rincipal repayments included in lease o$li(ations.

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i". 9urchase commitments under noncancela$le contracts to the e+tent thatre!uirements e+ceed normal usa(e.

". 9referred stoc' di"idend re!uirements of majority%owned su$sidiaries."i. Interest on recorded pension lia$ilities."ii. Kuarantees to pay fi+ed char(es of unconsolidated su$sidiaries if the

re!uirement to honor the (uarantee appears imminent.2c4 )ther fi+ed char(es-such as imputed interest in the case on non%interest or low

interest%$earin( o$li(ations. These are not periodical fund drains.

5or each of the a$o"e cate(ories* the correspondin( income to $e included in theratio computation should $e adjusted accordin(ly. Re(ardin( fi+ed char(es* thoseitems not ta+ deducti$le must $e ta+ adjusted. This is done $y increasin( them $y anamount e!ual to the income ta+ that would $e re!uired to o$tain an after%ta+ incomesufficient to co"er the fi+ed char(es. The ta+ rate to $e used should $e $ased on therelation of the ta+es on income from continuin( operations to the amount of pre%ta+income from continuin( operations-the company&s effecti"e ta+ rate.

@. A company normally si(ns a lon(%term purchase contract to either insure that itssupply of essential raw material is not interrupted or to (et a fa"ora$le purchase

discount* or $oth. In times of fa"ora$le economic conditions* the analyst need notworry a$out most such commitments 2indeed* they are a positi"e factor4. The onlye+ception is when such commitments reflect amounts in e+cess of re!uirements(i"en e+pected sales. Accordin(ly* if the analyst concludes that the purchasecommitments represent the minimum re!uired supplies* sHhe can justifia$ly e+cludethe commitments from fi+ed char(es. If the analyst includes the commitments in fi+edchar(es* income should $e adjusted to reflect the ta+%deducti$le nature of thepurchase that will e"entually $e recorded as cost of (oods sold. 9roceeds from theforced sale of e+cess supplies can also $e deducted on an estimated $asis.

@D. /et income includes items of re"enue that do not (enerate immediate cash. It alsoincludes e+penses that do not re!uire the immediate use of cash. 5or a measure of

cash a"aila$le to meet fi+ed char(es* the more rele"ant fi(ure is Fcash pro"ided $yoperationsF reported in the statement of cash flows. /et income can sometimes $eused as a pro+y of this more appropriate measure of cash a"aila$ility.

@G. ,ince Company is under the control of Company A* the latter can siphon off fundsfrom it to the detriment of &s creditors. oreo"er* the customer%supplier relationshipwith Company A means that Company A has considera$le discretion in the allocationof re"enues* costs* and e+penses amon( the two entities in such a way as todetermine which company will show what portion of the total a"aila$le income. Thisa(ain can wor' to the detriment of Company &s creditors. As a lender to Company *one would want to write into the lendin( a(reement conditions that would pre"entparent Company A from e+ercisin( its controllin( powers to the detriment of the

lender.

0. 6e$t can ne"er $e e+pected to carry the ris's and returns of ownership $ecause of the fi+ed nature of its rewards. Also* it cannot ser"e as the permanent ris' capital of acompany $ecause it must $e repaid with interest. oreo"er* de$t is incurred on thefoundation of an e!uity $ase. Indeed* e!uity financin( shields or at least reduces theris's of de$t financin(. E!uity financin( also a$sor$s the losses to which a companyis e+posed. Conse!uently* the assertion is $asically accurate.

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1. The ad"anta(es of con"erti$le de$t are that the company is a$le to potentiallyenlar(e its e!uity $ase 2andHor at a potentially lower cost4 than it mi(ht otherwise $ea$le to with pure e!uity financin(. Also* it mi(ht $e a$le to sell e!uity shares at aprice in e+cess of the current mar'et price and to o$tain* in the interim* a lower interest cost $ecause of the con"ersion feature of the de$t. The disad"anta(es arethat a su$se!uent decline in the mar'et price of the stoc' can postpone con"ersionsu$stantially and indefinitely. This would lea"e the company with a de$t $urden that itwas not prepared to shoulder o"er the lon( term. Conse!uently* what may ha"e $eenconcei"ed of as temporary financin( can* in fact* $ecome lon(%term de$t financin(.

7. 2a4 #on(%term indentures span such an e+tended period of time that they are su$jectto many uncertainties and impondera$les. Conse!uently* lon(%term creditorsoften insist on the maintenance of certain ratios at specified le"els andHor controlso"er specific mana(erial actions and policies 2such as di"idends and capitale+penditures4. owe"er* no restricti"e co"enant or other contractual arran(ementcan pre"ent operatin( losses* which present the most serious ris' to lon(%termcreditors.

2$4 1. aintenance of a minimum de(ree of short%term li!uidity.

7. 9re"ention of the dissipation of e!uity capital $y retirement* refundin(* or thepayment of e+cessi"e di"idends.

?. 9reser"ation of e!uity capital for the safety of creditors.@. Insure the a$ility of creditors to protect their interests in a deterioratin(

situation.

?. The major reason why de$t securities are rated while e!uity securities are not restin the fact that there is a far (reater uniformity of approach and homo(eneity of analytical measures used in the e"aluation of credit worthiness than there is in thee"aluation of e!uity securities. This increased a(reement on what is $ein(measured in credit ris' analysis has resulted in widespread acceptance of andreliance on pu$lished credit ratin(s in many sectors of the analyst community.

@. In ratin( an industrial $ond issue* ratin( a(encies focus on the issuin( company&sasset protection* financial resources* earnin( power* mana(ement* and the specificpro"isions of the de$t security. Asset protection is concerned with measurin( thede(ree to which a company&s de$t is co"ered $y its assets. 5inancial resourcesencompass* in particular* such li!uid resources as cash and other wor'in( capitalitems. 5uture earnin( power is a factor of (reat importance in the ratin( of de$tsecurities $ecause the le"el and the !uality of future earnin(s determine importantlya company&s a$ility to meet its o$li(ations. Earnin(s power is (enerally a morerelia$le source of security than is asset protection. ana(ement a$ilities* philosophy*depth* and e+perience always loom importantly in any final ratin( jud(ment. Throu(hinter"iews* field trips and other analyses the raters pro$e into mana(ement&s (oals*

the plannin( process as well as strate(ies in such areas as research andde"elopment* promotion* new product plannin( and ac!uisitions. The specificpro"isions of the de$t security are usually spelled out in the $ond indenture.

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. The analyst who can effecti"ely e+ecute financial statement analysis can alsoimpro"e on the pu$lished $ond ratin(s. Indeed* effecti"e financial statement analysisis possi$ly e"en more "alua$le in the "aluation of de$t securities than in the case of e!uity securities. ond ratin(s co"er a wide ran(e of characteristics and they presentopportunities for those who can $etter identify 'ey differences within a ratin(classification. oreo"er* ratin( chan(es (enerally la( the mar'et. This la( presentsadditional opportunities to an analyst who with superior s'ill and alertness canidentify important chan(es $efore they $ecome (enerally reco(ni8ed.

B.Companies hire $ond%ratin( a(encies to rate their de$t $ecause these ratin(s are ane+ternally (enerated* independent si(nal of the company&s creditworthiness and!uality. In"estors would rely less on ratin(s if they were produced in%house $ecauseof mana(ement&s incentives to report hi(h !uality and of mana(ement self%interest. Inshort* they act as independent si(nals of de$t !uality.

10-19


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ELERCI,E,

E+ercise 10%1 270 minutes4

Current Ratio 3uic' Ratio Wor'in( Capital

1.M /o chan(e /o chan(e /o chan(e7. /o chan(e /o chan(e /o chan(e?. Increase Increase Increase@. 6ecrease /o chan(e 6ecrease. 6ecrease 6ecrease 6ecreaseB. 6ecrease 6ecrease 6ecrease. Increase Increase /o chan(eD. 6ecrease 6ecrease /o chan(eG. Increase Increase Increase10. /o chan(e 6ecrease /o chan(e

M Assumes a sufficient amount is pro"ided for in the Allowance for ad 6e$ts.

E+ercise 10%7 2?0 minutes42a4 2$4 2c4 ;ournal Entry E+planation

1. /E /E 6 C)K, 00 Cost of (oods sold increases $y 00N R.E. 00 a"era(e in"entory increases $y 70N ratio

2c4 decreases.7. I 6 /E Accts Rec$le 6enominator will increase $y half the

,ales amount of the numerator causin( the 2a4ratio to increase. 6enominator of ratio 2$4will increase causin( the ratio to decrease.There is no effect on the components ofratio 2c4.

?. I 6 /E Allow for ad 6e$ts The numerator in ratio 2a4 won&t chan(e Accts Rec$le and the denominator will decrease thus

increasin( the ratio. ecause ratio 2a4 willincrease* ratio 2$4 will decrease as thea"era(e accounts recei"a$le turno"erincreases. Ratio 2c4 is unaffected.

@. I 6 /E ad 6e$t E+pense Ratio 2a4 will increase due to theAccts Rec$le decrease in the denominator. Ratio 2$4 will

decrease due to the increase in thedenominator* which is due to the increasein ratio 2a4. Ratio 2c4 is unaffected.

. /E /E I C)K, )nly ratio 2c4 is affected. The numerator

In"entory increases while the denominatordecreases.

B. /E /E I R.E. 00 /either ratio 2a4 nor 2$4 are affected. TheC)K, 00 a"era(e in"entory will decrease $y 0O of

the decrease in the numerator in ratio 2c4due to the a"era(in( effect* thusincreasin( the ratio.

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E+ercise 10%? 2?0 minutes4

2a4 2$4 2c4 ;ournal Entry E+planation

1. /E /E /E Allow for ad 6e$ts ,ince we use the net A.R. inAccts Rec$le computation of ratio* there is no effect.

7. /E /E 6 C)K, /either ratio 2a4 nor 2$4 is affected. The

R.E. cost of (oods sold increases $y P1*000*and a"era(e in"entory will increase $yP00 2due to the a"era(in( effect4* thusdecreasin( ratio 2c4.

?. /E /E I C)K, )nly ratio 2c4 is affected. TheIn"entory numerator increases while the

denominator decreases.

@. /E /E I #oss /either ratio 2a4 nor 2$4 is affected.In"entory A"era(e in"entory will decrease $y

P1*00 2half of P?*0004* increasin( ratio 2c4.

. /E /E I R.E. /either ratio 2a4 nor 2$4 is affected. TheC)K, a"era(e in"entory will decrease $y half

of the decrease in the numerator.

B. I 6 /E ,ales 6enominator of ratio 2a4 decreases $yAccts Rec$le half the amount the numerator decreases*

causin( ratio 2a4 to increase. 6enominatorof ratio 2$4 will increase* causin( it todecrease. There is no effect on ratio 2c4.

E+ercise 10%@ 2@ minutes4

a. ethods to window dress financial statements to impro"e the current and !uic'

ratios1. 9ay off accounts paya$le with cash. This would ha"e the effect of reducin(

$oth current assets and current lia$ilities $y the same amount* thus increasin(the current ratio and !uic' ratio.

7.M In"est additional capital funds at year%end. This would increase cash withoutaffectin( current lia$ilities.

?.M ,ell fi+ed assets for cash or short%term notes. This would increase currentassets* $ut decrease only fi+ed assets. Thus* the current and !uic' ratioswould impro"e.

@.M orrow cash $y incurrin( lon(%term lia$ilities 2notes or $onds4. This wouldincrease cash* $ut would not affect current lia$ilities* since the purpose is toma'e them lon(%term lia$ilities.

.M 6efer incurrin( "arious e+penses* such as ad"ertisin(* research andde"elopment* and mar'etin(* alon( with reducin( capital e+penditures.

B. Jeep the cash receipts $oo's open lon(er* in an effort to show hi(her recei"a$les or collections. This method is a hi(hly irre(ular and manipulati"ede"ice.

M These procedures are normal $usiness transactions that cannot usually $e consideredmanipulati"e in character. They may $ecome manipulati"e when they ha"e no sound$usiness justification and are underta'en solely to influence the measures used $youtside analysts.

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E+ercise 10%@-concluded

$. The analyst could* if all underlyin( e"idence and documents were a"aila$le*detect each of these methods. owe"er* sufficient e"idence* such as in"oices andthe $oo's of ori(inal entry* will most li'ely not $e a"aila$le for inspection.oreo"er* these methods may not $e reco(ni8a$le throu(h the usual analysis of

financial statements of the company. If sufficient e"idence were a"aila$le* thefollowin( are techni!ues that may $e used to detect the methods descri$ed in a.

1. The analyst could determine the company&s usual payment policies* andcompare them with those employed at year%end. ,Hhe could loo' at the termsof the lia$ilities* to see if they were paid at the most $eneficial time-in other words* if any economic $enefit was deri"ed $y payin( them earlier than due or when normally paid. ,Hhe could inspect the payments in the first month of thefollowin( year* to see if lia$ilities were paid disproportionately to year%end*ta'in( into account due dates and normal re!uirements. An unusually lowin"entory at year%end mi(ht also indicate failure to purchase merchandise atyear%end in an effort to impro"e the !uic' ratio.

7. The analyst could analy8e the timin( of in"estments and the use to which theywere put. If sHhe sees lar(e capital infusions at year%end* and that thesein"estments were represented $y idle cash* or $y mar'eta$le securities whichare not related to operations* and where there is little pro$a$ility of such funds$ein( re!uired for operations in the near future* the reason mi(ht $e windowdressin(.

?. Contracts and in"oices mi(ht $e e+amined to see when they were entered intoand when they were recorded.

@. The procedures for in"esti(ation of e+cessi"e $orrowin( at year%end are thesame as those for e+cessi"e in"estments of e!uity funds 27. a$o"e4. Also* thecontracts should $e studied to determine if they are $ona fide loans.

. The purchase journal and cash dis$ursements journal should $e e+amined to

compare e+penses incurred towards the end of the year with e+penses at the$e(innin( of the followin( year* and the reasons for lar(e differences.

B. To determine if the $oo's are $ein( 'ept open too lon(* the analyst wouldstudy such documents as the underlyin( in"oices and canceled chec's todetermine their actual dates* and to compare this with the dates recorded. ,Hhemi(ht also confirm material accounts with customers as of the year%end.

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E+ercise 10% 2?0 minutes4

AM M CM 6M

1. /E /E IHIQ6 IHIQ6

7. 6H/EQ6 6H/EQ6 6H6QI 6H6QI

?. IH/EQI IH/EQI IHIQ6 IHIQ6

@. /EHIQ6 /EHIQ6 IHIQ6 IHIQ6

. /E /E 6H/EQ6 /E

B. /E /E /E IH/EQI

. /E /E IHIQ6 IHIQ6

D. /E /E 6H6QI 6H6QI

G. 6HIQ6 6HIQ6 /E /E

10. IH/EQI /E /E /E

M Ratio codes and definitionsA. Total de$t H Total e!uity. #on(%term de$t H Total e!uityC. 9re%ta+ earnin(s S 5i+ed char(es 25C4 H 5C6. 9reta+ C5) S 5C H 5C

E+ercise 10%B 27 minutes4

I. $

II. a

III. $

IV. $

V. d

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9R)#E,

9ro$lem 10%1 2B0 minutes4

a. ,hort%term li!uidity ratios for Camp$ell ,oup

1. ?B H @ Q P1*BB. H P1*7GD.1 Q 1.7D

7. 2PD0. ?1 S P77. ?7 S PB7@. ??4 H P1*7GD.1 @ Q 0.B

?. PB*70.D 1? H 2PB7@. ?? S [email protected] Q 10.@@

@. P@*7D.7 1@ H 2PD1G.D ?@ S PD1B.04H7 Q .71

. PB7@. ?? H 2PB*70.D H ?B04 Q ?B.7?

B. PD1G.D H 2P@*7D.7 H ?B04 Q BG.?1

. ?B.7? S BG.?1 Q 10.@

D. 2PD0. S P77.4 H P1*BB. Q 0.0B7

G. 2PD0. S P77.4 H P1*7GD.1 Q 0.0G

10.Endin( in"entoryUUUUUUUU P D1G.D ?@SCost of (oods soldUUUUUUU. @*7D.7 1@% e(innin( in"entory.UUUUUU. D1B.0 2(i"en4% 6epreciationUUUUUUUUUU. [email protected] 1DQ9urchases.UUUUUUUUUUU P@*0.G

2P7.7 @1 H 2P@*0.G H ?B04 Q @B.?B

11. 10.@ % @B.?B Q G.1D

17. P@@D.@ B@ H P1*7GD.1 @ Q ?@.@O

$. Camp$ell


25/58


9ro$lem 10%1-concluded

c. Current assets usin( 5I5) Q P1*BB. ?B S [email protected] 1? Q P1*0.1

C)K, 25I5)4 Q C)K, 2#I5)4 S #I5) reser"eQ P@*7D.7 S [email protected] % 2PG0@ % PD1B4 Q P@*[email protected]

1. P1*0.1 H P1*7GD.1 Q 1.?@. P@*[email protected] H 2PG0@.@ S PG0@4H7 Q @.1

. PB7@. ?? H 2PB*70.D 1? H ?B04 Q ?B.7?

B. PG0@.@ H 2P@*7D.7 H ?B04 Q B.@B

. ?B.7? S B.@B Q 117.BG

d. 6isre(ardin(* for purposes of this analysis* the prepaid e+penses and similar unsu$stantial items enterin( the computation of the current ratio* we are left withthe four major elements that comprise this ratio-those are cash* accountsrecei"a$le* in"entories* and current lia$ilities. If we define li!uidity as the a$ility to$alance re!uired cash outflows with ade!uate inflows* includin( an allowance for une+pected interruptions of inflows or increases in outflows* we must as' 6oesthe relation of these four elements at a (i"en point in time1. easure and predict the pattern of future fund flows7. easure the ade!uacy of future fund inflows in relation to outflowsnfortunately* the answer to $oth of these !uestions is primarily no. The currentratio is a static concept of what resources are a"aila$le at a (i"en moment in timeto meet the o$li(ations at that moment. The e+istin( reser"oir of net funds doesnot ha"e a lo(ical or causal relation to the future funds that will flow throu(h it.

:et it is the future flows that are the su$ject of our (reatest interest in theassessment of li!uidity. These flows depend importantly on elements not included in the ratio itself* such as sales* profits* and chan(es in $usinessconditions. There are at least three conclusions that can $e drawn1. #i!uidity depends to some e+tent on cash or cash e!ui"alents $alances* $ut to

a much more si(nificant e+tent on prospecti"e cash flows.7. There is no direct or esta$lished relation $etween $alances of wor'in( capital

items and the pattern that future cash flows are li'ely to assume.?. ana(erial policies directed at optimi8in( the le"els of recei"a$les and

in"entories are mainly directed towards efficient and profita$le assetutili8ation and only secondarily towards li!uidity.

These conclusions o$"iously limit the "alue of the current ratio as an inde+ of li!uidity. oreo"er* (i"en the static nature of this ratio and the fact that it consistsof items that affect li!uidity in different ways* we must e+ercise caution in usin(this ratio as a measure of li!uidity.

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e. Accounts recei"a$le turno"er rates or collection periods can $e compared toindustry a"era(es or to the credit terms (ranted $y the company. When thecollection period is compared with the terms of sale allowed $y the company* thede(ree to which customers are payin( on time can $e assessed. In assessin( the

!uality of recei"a$les* the analyst should remem$er that a si(nificant con"ersionof recei"a$les into cash* e+cept for their use as collateral for $orrowin(* cannot$e achie"ed without a cut$ac' in sales "olume. The sales policy aspect of thecollection period e"aluation must also $e 'ept in mind. A company may $e willin(to accept slow%payin( customers who pro"ide $usiness that is* on an o"erall$asis* profita$leN that is* the profit on sale compensates for the e+tra use $y thecustomer of the company funds. This circumstance may modify the analyst&sconclusions re(ardin( the quality of the recei"a$les $ut not those re(ardin( their liquidity .

The current ratio computation "iews its current asset components as sources of funds that can* as a means of last resort* $e used to pay off the current lia$ilities.

Viewed this way* the in"entory turno"er ratios (i"e us a measure of the !uality aswell as of the li!uidity the in"entory component of the current assets. The !ualityof in"entory is a measure of the company&s a$ility to use it and dispose of itwithout loss. When this is en"isa(ed under conditions of forced li!uidation* thenreco"ery of cost is the o$jecti"e. In the normal course of $usiness* the in"entoryshould* of course* $e sold at a profit. Viewed from this point of "iew* the normalprofit mar(in reali8ed $y the company assumes importance $ecause the fundsthat will $e o$tained* and that would theoretically $e a"aila$le for payment of current lia$ilities* will include the profit in addition to the reco"ery of cost. In $othcases* costs of sales will reduce net proceeds. In practice* a (oin( concerncannot use its in"estment in in"entory for the payment of current lia$ilities$ecause any drastic reduction in normal in"entory le"els will surely cut into the

sales "olume. The turno"er ratio is a (au(e of li!uidity in that it con"eys ameasure of the speed with which in"entory can $e con"erted into cash. In thisconnection* a useful additional measure is the con"ersion period of in"entories.

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9ro$lem 10%7 2@ minutes45uture Technolo(ies* Inc.

Cash 5orecast5or :ear Ended 6ecem$er ?1* :ear 7

Cash* ;anuary 1* :ear 7 P @7*000

Cash CollectionsAccounts recei"a$le* ;an. 1*:ear 7 P G0*000,alesM @7*00

B7*00#ess discount on sales a 2G@4#ess acct. rec.* 6ec. ?1* :ear 7 $ 27*1DD4 @DG*?BTotal cash a"aila$le ?1*?B

Cash 6is$ursementsAccounts paya$le* ;an 1.* :ear 7 D*0009urchases c ?B*B0#ess Acct. pay.* 6ec. ?1* :ear 7 d 21?7*114 ?07*7@G

Accrued ta+es paid 10*D00)ther e+penses-Cash e 11B*0 @7G*GGCash a"aila$le* 6ec. ?1* :ear 7 P 101*BD

Cash needed for e!uipment 21*0004Cash $alance desired 2?0*00046eficiency in Cash 2need to $orrow4 P210?*7?74

M ,ales P@0*000 + 1.0 Q P@7*00Cost of (oods sold P?17*000 + .GD Q P?0*B0

a P@7*00 + 10O + 7O Q PG@ 2discount on sales4

$ P@7*00 + G0O + 2B0H?B04 Q P0*D

P@7*00 + 10O + 210H?B04 Q 1*?1? P7*1DD 2Accounts recei"a$le* 6ec. ?1* :ear 74c

:ear 7 Cost of (oods sold..UUUU... P?0*B0Endin( in"entoryUUUUUUUUU.. G0*000 2(i"en4Koods a"aila$le for sale.UUUUU... P?G*B0e(innin( in"entoryUUUUUUUU ?G*0009urchasesUUUUUUUUUUUU.. P?B*B0

d Accounts 9ay.* 17H?1H:ear 7 Q :r 7 9urchases + 2A.9.* 17H?1H:ear 1 H :r 1 9urchases4Accounts 9ay.* 17H?1H:ear 7 Q P?B*B0 + 2PD*000 H P710*0004 Q P1?7*11

e :ear 1,alesUUUUUUUUUUUU

U

P @0*000

Cost of (oods soldUUUUUU. 2?17*00046epreciationUUUUUUUUU..

21*0004

/etincomeUUUUUUUUUU.

217*0004

)ther e+pensesUUUUUUUU

P 111*000

)ther e+penses 2:ear 74 Q P111*000 + 1.0 Q P11B*0

10-27


28/58


9ro$lem 10%? 2@ minutes4

RA CorporationCash 5orecast $efore 9olicy Chan(es5or :ear Ended 6ecem$er ?1* :ear 7

Cash* ;anuary 1* :ear 7UUUUUUUU P D0*000

Cash CollectionsAccounts recei"a$le* ;an. 1UUUU P10*000,ales 2D00*000 + 110O4UUUUUU. DD0*000#ess Accounts rec$le.* 6ec. ?1 a.. 21B*0004 DB*000

Total cash a"aila$le UUUUUUUUU.. G@*000

Cash 6is$ursementsAccounts paya$le* ;an. 1UUUUU. P1?0*0009urchases $UUUUUUUUUU.. B*000#ess Accounts pay.* 6ec. ?1 cU... 27@@*0004 @?*000Increase in notes paya$leUUUU... 21*0004

Accrued ta+esUUUUUUUUUU. 70*000Cash e+penses dUUUUUUUU. 7D*00 D0B*00/et cash flowUUUUUUUUUUUU... P1?D*00

Cash $alance desiredUUUUUUUUU 0*000Cash e+cessUUUUUUUUUUUUU. P DD*00

/otesa ?B0 days H 2PD00*000HP10*0004 Q B. days

Applied to :ear 7 sales PDD0*000 + 2B.H?B04 Q P1B*000

$ :ear 7 Cost of sales 2P70*000 + 110O4UUUUUU P7*000Endin( in"entory 2(i"en4UUUUUUUUUUU 10*000Koods a"aila$le for saleUUUUUUUUUUU 77*000e(innin( in"entoryUUUUUUUUUUUUU B*0009urchasesUUUUUUUUUUUUUUUUU.. PB*000

c 9urchases + 2:ear 1 Accounts paya$le H :ear 1 9urchases4Q PB*000 + 2P1?0*000 H P?0*0004 Q P7@@*000

d Kross profit 2PDD0*000 % P7*0004UUUUUUUU P?0D*000#ess /I 2110O of P70*000 :ear 1 /I4 S 210O of :ear 1 depreciationM4 2P77*000 S P7*004U P7@*00

6epreciation noncashUUUUUUUUUUUU.. 7*000 @G*00)ther cash e+penses P7D*00M 6epreciation e+pense is not e+pected to increase $y 10O.

10-28


29/58


9ro$lem 10%?-concluded

a. What%If Analysis of 9roposed Credit 9olicy Chan(e

A.R.* 6ec. ?1 PDD0*000 2sales4 + 2G0H?B04UU.

P 770*000

#ess A.R. from forecast statement2a$o"e4.....

1B*000

Additional cash neededUUUUUUUUUU *000Cash e+cess 2a$o"e4UUUUUUUU...UU.. DD*00Cash e+cess for this proposalUUUUUUU P ??*00

$. What%If Analysis of 9roposed Collection 9eriod Chan(e

A.R.* 6ec. ?1 PDD0*000 2sales4 + 2170H?B04UU

P 7G?*000

#ess A.R. from statement 2a$o"e4UUUUU.. 1B*000

Additional cashneededUUUUUUUUUU.

17D*000

Cash e+cess 2a$o"e4UUUUUUUUUUU.. DD*00Cash to $e$orrowedUUUUUUUUUUU..

P ?G*00

c. What%If Analysis of 9roposed 9ayment 9eriod Chan(e

A.9.* 6ec. ?1 PB*000 2purch.4 + 2B0H?B04U. P10G*00A.9. from statement 2a$o"e4UUUUUUUU...

7@@*000

Additional cash neededUUUUUUUUUU 1?@*00Cash e+cess 2a$o"e4UUUUUUUUUUU. DD*00Cash to $e $orrowedUUUUUUUUUUU. P @B*000

10-29


30/58


9ro$lem 10%@ 2@0 minutes4

Top CorporationCash 5orecast

5or :ear Ended 6ecem$er ?1* :ear B

Cash $alance 21H1H:ear B4

UUUUUU..

P ?*000

Cash receipts

Accounts recei"a$le* ;an. 1..U...

P *000

,alesUUUUUUUUUUUUU.

@17*00

Accounts recei"a$le* 6ec. ?1

2,ales* P@17*00 + G0H?B04UU..

210?*174

Cash receiptsU.

UUUUUUUU

?D@*?

Total casha"aila$leUUUUUUUU...

P@1G*?

Cash dis$ursements

Accounts paya$le* ;an. 1 .UUU

P B*000

9urchases 1UUUUUUUUU

??1*0

Accounts paya$le* 6ec. ?1UUU

2177*0004 7@*0

9ayment of notespaya$leUUU. 7*00

Accruedta+esUUUUUUUUU

G*000

Cash e+penses 7UUUUUUU

110*70 ?GB*00

Estimated cash$alanceUUUUUUU.

P 77*D

inimum cash $alancedesiredUUU.

0*000

Re!uired to

$orrowUUUUUUUUU.

P 7*17

/otes1

e(innin( in"entoryUUUUUUUU. P ?7*000S 9urchases (plug)UUUUUUUUU ??1*0Koods a"aila$le for sale.UUUUUU. ?B?*0% Endin( in"entoryUUUUUUUUU. *000

10-30


31/58


Cost of sales 2P@17*00 + .04UUUU P7DD*07

Kross profit 2?0O of sales4UUUUUU P17?*06epreciation 2P7*000 % P71*004UUU.. ?*00/et income 2e+cludes other e+penses4.. 170*70)ther e+penses 2plu(4UUUUUUU.U 110*70/et income 2(i"en4UUUUUUUUU... P 10*000

10-31


32/58


9ro$lem 10% 2B0 minutes4

a. Rele"ant information that pro$a$ly can $e deri"ed from the notes to thefinancial statements includes1. 6etails of Kant&s $an' credit* includin( total line of credit* portion currently

unused* interest rates* and terms of credit.7. Impacts of any consolidated su$sidiaries on the li!uidity of the

consolidated $alance sheet of Kant. ,u$sidiaries usually maintain separatecredit facilitiesN therefore* sol"ency of a su$sidiary may not necessarily $eaccessi$le to the parent company&s creditors.

?. Kant&s pension fundin( o$li(ations. Is there an unfunded lia$ility If so*what are the future financial o$li(ations

Additional rele"ant information that you should attempt to o$tain from Kant&smana(ement includes@. 9rior years< 2andHor !uarterly4 statements of cash receipts and payments.. 5orecasts statement 2one or more years4 of due dates and amounts for its

recei"a$les and paya$les.B. ud(et of planned capital e+penditures.

. ud(et of planned lon(%term financin(.

$. 3ualitati"e assessments that you would want to ma'e re(ardin( KantCorporation and its industry include1. 5inancial fle+i$ility of Kant in terms of its a$ility to li!uidate assets without

affectin( profita$ility.7. #e"el of inflation 2prices chan(es4 applica$le to Kant and its industry

2includin( those for raw materials* unioni8ed la$or* product pricefle+i$ility4.

?. Kant&s competiti"eness in the domestic industry 2that is* how up%to%date isits plant and e!uipment4. Also* will major capital e+penditures $e re!uiredin the near term

@. ow does the industry and Kant compete internationally Are there

ad"erse international industry de"elopments $eyond the control of KantIn addition to these (eneral !ualitati"e assessments of Kant* you would want toconsider the followin( more specific !ualitati"e assessments. Cost Control 9ro(ram

ow has the cost cuttin( pro(ram impacted its financial fle+i$ilityow lean is its operationsAre there assets that can $e disposed of without impactin( producti"ity or profita$ility ne(ati"elyas the pro(ram $een too intense such that lon(%term opportunities arelost

B. FCommodityF )rientation of 9roduct #ineWhat has happened with commodity prices o"er the past se"eral yearsAre the mar'ets for Kant&s "arious product lines soft

. .,. 9lant 5acilitiesow has the stren(thHwea'ness in the .,. dollar affected the company&scompetiti"e position o"er the past yearsow competiti"e is Kant internationallyWill it $e forced to di"ersify its operations internationally andHor up(radeplant producti"ityow would a major sustained capital e+penditure pro(ram affectsol"ency

10-32


33/58


9ro$lem 10%B 2B0 minutes4

a.

Ratio :ear :ear B

1. Current ratio :ear PB1*000HP@0*000UUUUUU. 1.

:ear B PD@*000HP@*000UUUUUU. 1.B

7. 6ays& sales in recei"a$les 2P70*000 H 2P1*000H?B04UUUU... @BB 2P7*000 H 2P1DB*000H?B04UUUU... @D

?. In"entory turno"er PGG*000H2P?7*000SP?D*0004H7UU.. 7.D?B P170*000H2P?D*000SPB*0004H7UU 7.

@. 6ays& sales in in"entory

P?D*000H2PGG*000H?B04UUUUUU. 1?DB PB*000H2P170*000H?B04UUUUU.. 1BD

. 6ays& purchases in accounts paya$le P7?*000H2P10*000M H?B04UUUUU GB P7G*000H2P1?D*000M H?B04UUUUU B

* Purchases Year 5 Year 6

Cost of salesUUUUUUUU... P GG*000 P170*000S Endin( in"entoryUUUUUU ?D*000 B*000Koods a"aila$le for saleUUU.. 1?*000 1B*000% e(innin( in"entoryUUUU... ?7*000 ?D*0009urchasesUUUUUUUUUU P10*000 P1?D*000

B. Cash flow ratio P*00 H P@0*000UUUUUUU.U. 0.1GB PB*@00 H P@*000UUUUUUU.U. 0.17

$. ost of the li!uidity measures of XETA do not re"eal any si(nificant chan(es from :ear to :ear B. owe"er* there is some deterioration in the in"entory turno"er.This deterioration is e"en more e"ident in the days& sales in in"entory measures.oreo"er* the li!uidity inde+ also su((ests that the li!uidity position of XETA hasdeteriorated from :ear to :ear B. Also notice that $ecause of a lower le"el of

operatin( cash flows* the cash flow ratio shows a si(nificant decline. ,till* due tothe short time span of this analysis* one would want to e+amine another year or two 2say* :ears ? and @4 to see if these chan(es reflect a lon(er%term trend inli!uidity.

10-33


34/58


9ro$lem 10% 2G0 minutes4

a. ,ummary of Ratio Analysis Results700

1. #on(%term de$t to e!uity capital....................... 0.0D 2P0HPB*@D4

7. Total lia$ilities to total lia$ilities and e!uity.... 0.7 2P1B*?0HP7?*714

?. Total lia$ilities to e!uity..................................... 7.D 2P1B*?0HPB*@D4

@. Cash from operations to lon(%term de$t.......... 10.7 2P*?10HP04

. E!uity capital to 99E 2net4................................. ?.D@ 2PB*@DH1*BG14

$. 6ell


35/58


9ro$lem 10%D 2 minutes4

a. Computation of :ear 10 capital structure and sol"ency ratios for Camp$ellre!uires that we determine the followin( component measures for :ear 10

#on(%term de$t/otes paya$le................................................................... P G7.G

Capital lease o$li(ations................................................. 17 .G#on(%term de$t 17........................................................ D0.D6eferred income ta+es 20O4 1B................................. 11.B)ther #ia$ilities 1....................................................... 7D.Current #ia$ilities @...................................................... 1*7GD .1Total de$t........................................................................... P7*70.0

E!uity Capital)wners& e!uity @........................................................... P1*BG1.D6eferred income ta+es 20O4 1B................................. 11.Binority interests 1D.................................................... B .?Total e!uity........................................................................ P1*DB.

1. P7*70.0 H P1*DB. Q 1.71

7. P7*70.0 H P@*11.B Q 0.

?. 2PD0.D S P11.B S P7D.4 H P1*DB. Q 0.1

@. P1*DB. H P7*70.0 Q 0.D?

. P1*1. ? H P1*DB. Q 0.G7

B. P1*7GD.1 H P7*70.0 Q 0.D.

/umerator 6enominator

9reta+ income 7B..................................................... 1G.@ %%

Interest e+pense 100................................................ 111.B %%Int. with oper. leases 21H? of PB7.@ 1@?4.................. 70.D 70.DInterest incurred GD.................................................. 171.Gndistri$uted e!uity in earnin(s in non% consolidated su$s. 1BGA 2P1?.0% P.@4.................. 2 .B4 0 .0?0B.7 1@7.

Ratio Q P?0B.7 H P1@7. Q 7.1@D.

/umerator 6enominator

Cash from ops $efore ta+M......................................... B1G. %%Interest e+pense ........................................................ 111.B %%Interest incurred ........................................................ %% 171.G

Interest portion of op leases...................................... 70 .D 70 .D1.G 1@7.

M C5) B@ P@@D.@ S Current ta+ e+pense P11.1 17@A Q PB1G.

Ratio Q P1.G H P1@7. Q .7

G. P?B.@ H P7*70.0 Q 0.1B

10-35


36/58


9ro$lem 10%D-concluded

$. We would compute the total de$t to total capitali8ation as follows

2a4 #on(%term de$t2$4 )ther lia$ilities2c4 6eferred income ta+es 2assumin( 100O considered as lia$ilities42d4 a S $ S c2e4 Total e!uity2f4 inority interests

9ro$a$ly the closest we can come to reconstruct Camp$ell&s computation of ??.O* item 17* is as follows 2PD0.D S P7D.4 H 2PD?@.? S P1*BG1.D4 Q ??O.This computation omits deferred ta+es and minority interests.

10-36

?D.0O R1CD2f4PAB.?RA@4P1*BG1.D2e4P1*0BG.@2d

[email protected]


37/58


9ro$lem 10%G 2@ minutes4

a. 1. Ratio of Earnin(s to 5i+ed Char(esTe+t reference /umerator 6enominator

2a4 9re%ta+ income.................................................. P@*B00 P %%2$4 Interest e+pensed............................................. @00 %%

2h4 Interest incurred............................................... %% @@02d4 Interest part of operatin( rental e+pense...... 170 1702f4 Amorti8ation of prior capitali8ed interest...... B0 %%2(4 ndistri$. inc. of Y0O owned affiliates........ 2?00 4 %%

P@*DD0 PB0Ratio Q P@*DD0 H PB0 Q D.1

7. Ratio of Cash 5rom )perations to 5i+ed Char(es/umerator 6enominator

9re%ta+ income....................................................... P@*B00 P %%

Add (Deduct) adjustents6epreciation........................................................... B00 %%Amorti8ation of $ond premium............................ 2?004 %%,hare of minority interest in income................... 700 %%ndistri$uted income of affiliates....................... 2?004 %%Increase in accounts recei"a$le........................... 2G004 %%6ecrease in in"entory............................................ D00 %%Increase in accounts paya$le............................... 00 %%9re%ta+ cash pro"ided $y operations.................. P*@00 %%Int. e+p. 2P@004 S ond premium amor 2P?004..... 00 %%Interest incurred..................................................... @@0

Interest portion of capital leases......................... 170 170PB*770 PB0Ratio Q PB*770 H PB0 Q 11.11

?. Earnin(s Co"era(e of 9referred 6i"idendsP@*DD0 H ZPB0 S P@00H21 % 0.@04 [ Q ?.GD

$. The company&s co"era(e ratios su((est the e+istence of sufficient earnin(sand cash flows to co"er its fi+ed char(es. There is no e"idence of concernfrom any of these three co"era(e ratios. 5or a more complete analysis* we

would want to collect "alues from other firms 2competitors4 and additionalprior years for comparati"e analyses.

10-37


38/58


9ro$lem 10%10

a. 1. Ratio of Earnin(s to 5i+ed Char(es/umerator 6enominator

9re%ta+ income....................................................... P*D00 P %%Int. incurred \ int. capitali8ed 2DD0S?@0%1704...... 1*100 1*770

Amorti8ation of $ond discount............................ 100 100Interest portion of rental e+pense........................ @00 @00Amorti8ation of prior capitali8ed interest........... 100 %%ndistri$uted inc. of Y0O owned affiliates....... 2@004 %%,hare of minority interest..................................... B00 %%

P*00 P1*70Ratio Q P*00 H P1*70 Q @.@D


9re%ta+ income....................................................... P *D00 P %%Add $ac' e+penses not re!uirin( cash6epreciation 2includes amorti8ation of pre"iously capitali8ed interest4............................ 1*700 %%Amorti8ation of $ond discount............................ 100 100,hare of minority interest..................................... B00 %%6eferred ta+es-already added $ac'.................. %% %%Increase in in"entories.......................................... 27*0004 %%6ecrease in accounts recei"a$le......................... 1*B00 %%Increase in accounts paya$le............................... 7*000 %%#ess ndistri$uted income of affiliates.............. 2@004 %%

9re%ta+ cash pro"ided $y operations.................. D*G00 %%Interest e+pensed-$ond discount add $ac'..... 1*100 %%Interest portion of rental e+pense........................ @00 @00Interest incurred..................................................... 1*770

P10*@00 P1*70Ratio Q P10*@00 H P1*70 Q B.0@

?. Earnin(s Co"era(e of 9referred 6i"idendsRatio Q P*00 H ZP1*70 S P@00H21 % .@04 [ Q ?.7?

$. The company&s co"era(e ratios su((est the e+istence of sufficient earnin(s

and cash flows to co"er its fi+ed char(es. There is no e"idence of concernfrom any of these three co"era(e ratios. 5or a more complete analysis* wewould want to collect "alues from other firms 2competitors4 and additionalprior years for comparati"e analyses.

10-38


39/58


9ro$lem 10%11 2@0 minutes4

a. 1. Ratio of Earnin(s to 5i+ed Char(es/umerator 6enominator

9re%ta+ income....................................................... PB*700 P %%Interest e+pense 2DD0 S ?@0 % 1704....................... 1*100 %%

Interest incurred 2DD0 S ?@04................................. %% 1*770Amorti8ation of $ond discount............................ 100 100Interest portion of rental payments..................... @00 @00Amorti8ation of capitali8ed interest..................... D0 %%ndistri$uted income of Y0O owned affiliates. 2D004 %%

,hare of minority interest B00 ]]]] P*BD0 P1*70

Ratio Q P*BD0 H P1*70 Q @.@


9re%ta+ income....................................................... PB*700 P %%Add 2deduct4 items to con"ert to cash $asis6epreciation........................................................... 1*700 %%Amorti8ation of $ond discount ........................... 100 %%inority interest in income................................... B00 %%ndistri$uted income of affiliates....................... 2D004 %%Chan(es in

Accounts recei"a$le............................................ B00In"entories............................................................ 21B04 %%9aya$le and accrued e+penses......................... 170 %%

9re%ta+ cash from operations............................... *DB0 %%

Interest incurred 2DD0 S ?@04................................. %% 1*770Amorti8ation of $ond discount............................ %% 100Interest e+pense 2DD0 S ?@0 % 1704....................... 1*100Interest portion of rental e+pense........................ @00 @00

PG*?B0 P1*70Ratio Q PG*?B0 H P1*70 Q .@@

?. Earnin(s co"era(e of preferred di"idendsRatio Q P*7D0 H ZP1*70 S P@00H21 % .@04 [ Q ?.0

$. ased on the calculations in part a* the super"isor&s concerns a$out theco"era(e ratios are misplaced. Indeed* the company&s co"era(e ratios

su((est the e+istence of sufficient earnin(s and cash flows to co"er its fi+edchar(es. There is no e"idence of concern from any of these three co"era(eratios. 5or a more complete analysis* we would want to collect "alues fromother firms 2competitors4 and additional prior years for comparati"e analyses.

10-39


40/58


9ro$lem 10%17 20 minutes4

Interest incurred calculation5irst ort(a(e onds .0O of *00 Q ?

B.0O of 1*00 Q 1*00 1*@7,in'in( 5und 6e$entures B.O of 10*000 Q B0

Total interest incurred P7*0

a. Earnin(s Co"era(e Ratio on the 5irst ort(a(e onds 2pre%ta+ $asis4214 ?.? $ased on :ear earnin(s* 2P@*0 H P1*@74274 ?.1 $ased on %year a"era(e* Z2P@*0SP@*00SP@*00SP@*70SP@*0004H[H

P1*@7

Earnin(s Co"era(e Ratio on the ,in'in( 5und 6e$entures 2pre%ta+ $asis4214 .? $ased on :ear earnin(s* 2P@*0 H PB04274 B.D $ased on %year a"era(e* Z2P@*0SP@*00SP@*00SP@*70SP@*0004H[H

PB0

$. #on(%Term 6e$t to E!uity RatioRatio Q P?HP@ Q 0.@ @O of capital is de$t

)f e!uity capital* @7.BO 2P70*000MHP@*0004 is senior to common stoc'M P1.10 preferred 2?00*000 + P704..................................... P B*000

Class A shares................................................................. 1@*000P70*000

c. Earnin(s Co"era(e Ratio on the Cumulati"e Redeema$le 9referredInterest re!uirements for lon(%term de$t........................................... P7*0P1.10 preferred di"idend-ta+ adjusted 2?00*00042P1.14H21%.04..... BB0

Re!uired pre%ta+.................................................................................... P7*?

214 1. Q $ased :ear earnin(s* 2P@*0 H P7*?4274 1.B Q $ased on %year a"era(e* 2P@*@00 H P7*?4

d. Earnin(s per ,hare Computation Assumin( Con"ersionP@*0 :ear earnin(s $efore interest and ta+es 27*04 Interest e+penseP7*B 9re%ta+ income 21*??4 Ta+es 20O4P1*??D After%ta+ income 2??04 P1.10 preferred di"idends 2?00*000 shares + P1.104

P1*00D A"aila$le for common shareholders

1.D mil Common shares 1 mil. S 0.D mil. 2Class A Con"ersion4P 0.B Earnin(s per share

10-40


41/58


9ro$lem 10%1? 2@ minutes4

a. Computation of Income and E9, under 6e$t "s. E!uity 5inancin(

6e$t E!uity

Income $efore interest and ta+es-pre%e+pansion......... P70*000*000 P70*000*000

Additional income from e+pansion................................... @*000*000 @*000*000

Income $efore interest and ta+es-post%e+pansion....... 7@*000*000 7@*000*000

Interest e+pense 2BO42P70*000*0004SP1*000*000............. 27*700*000 4 21*000*000 4

Income $efore ta+es.......................................................... 71*D00*000 7?*000*000

Income ta+es 2@0O4........................................................... 2D*70*0004 2G*700*0004

/et income P1?*0D0*000 P1?*D00*000

Common shares outstandin(........................................... 7*000*000 7*@00*000

Earnin(s per share............................................................ PB.@ P.

$. Computation of E9, E!uality $etween 6e$t and E!uity 5inancin(

M EIT Q Earnin(s efore Interest and Ta+es.

,ol"in( for EIT yields

EIT Q PD*700*000

Interpretation When income $efore interest and ta+es is at PD*700*000*stoc'holders are indifferent $etween the de$t or e!uity financin( plans.

10-41

7*@00*000

.@04%421P1*000*000%M2EIT

7*000*000

.@04%421P7*700*000%M2EIT


42/58


9ro$lem 10%1@ 2 minutes4

a. 1. !uaranteed "u#sidiary De#t . Add P70*000*000 to $oth lon(%term de$t and tofi+ed assets. Rationale nder the e!uity method of accountin( for joint"entures* the de$t incurred is not reported on the $alance sheet of thepartners and therefore* this de$t should $e reflected in the adjusted de$t ratio

since #u$$oc' has (uaranteed the total inde$tedness of the joint "enture.

7. $%&' eserve. Add P700*000*000 to $oth in"entory and to retained earnin(s2i(norin( potential ta+ effects4. Rationale nder #I5) accountin(* #u$$oc'will report current costs for in"entory transactions in its income statement $utits $alance sheet amount for endin( in"entory will reflect =first%in* still%here*>or 5I,. Accordin(ly* the ,EC re!uires companies usin( #I5) to disclose innotes to the financial statements the amounts $y which #I5) in"entories must$e increased to reflect current costs. #u$$oc' reports that under 5I5)* itsin"entories would ha"e e+ceeded reported amounts $y P700*000*000.Accordin(ly* to reflect current costs* in"entories should $e stated on theadjusted $asis of 5I5)N also* retained earnin(s 2e+cludin( ta+ effects4 should

$e credited $y the same amount that in"entories are de$ited $y. An alternati"eapproach is to reco(ni8e a deferred ta+ lia$ility of P700*000 + current mar(inalta+ rate.

?. 'perating $eases. These lon(%term operatin( leases could $e capitali8ed. Thepresent "alue of these lon(%term leases must $e calculated usin( a discountrate. Assumin( 10O is the interest rate implicit in the lease* the present "alueis appro+imately P0*000*000. The present "alue amount should $e added tolon( term de$t and to fi+ed assets.

$. #on(%Term 6e$t to #on(%Term Capitali8ation efore Adjustments 2P millions4

#on(%term de$t#on(%term de$t S inority interest S ,hareholders& e!uity

Q PB H 2PB S P100 S P@00 S P1*B04 Q 7?.GO

#on(%Term 6e$t to #on(%Term Capitali8ation After Adjustments 2P millions4 #on(%term de$t S Kuaranteed de$t S #eases#on(%term de$t S inority interest S ,hareholders& e!uity S Kuaranteed de$t S In"entory Adjustment S #eases

Q 2PBSP70SP04 H 2PBSP100SP@00SP1*B0SP70SP700SP04 Q @1.BO

10-42


43/58


9ro$lem 10%1@-concluded

c. 1. Two points 2i4 5or fiscal years $e(innin( $efore 17H1BHG?* mar'eta$lesecurities were "alued at the lower of cost or mar'et under "&A" 2for mar'eta$le e!uity securities4 and A+ ,- 2for mar'eta$le de$t securities4.6urin( this period the mar'et "alue of securities were sometimes su$stantially

hi(her than shown on the $alance sheet* re!uirin( analytical adjustment.nder current practice* all mar'eta$le securities 2e+cept held%to%maturity de$tsecurities4 are "alued at mar'et. ence* only held%to%maturity de$t securitiesare potentially su$ject to mar'et adjustment. 2ii4 An analyst must reali8e thatthe lon(er the elapsed time since the $alance sheet date the (reater theli'elihood that mar'et "alues for mar'eta$le securities ha"e chan(ed. ence*for comparati"e analysis spannin( se"eral years* adjustments to mar'et may$e necessary for in"estment securities.

7. 6eferred income ta+es are created when a company uses different accountin(methods for income ta+ and financial reportin( such that so%called timin(differences in income occur. )ne school of thou(ht ar(ues that deferred ta+es

should $e reco(ni8ed as a lia$ility. The presumption is that timin( differenceswill re"erse in the future and the ta+es will $ecome paya$le or that chan(es inthe ta+ law could accelerate payment of such ta+es. )pponents ar(ue thatdeferred ta+es should $e included in shareholders& e!uity. The presumptionhere is that timin( differences are unli'ely to re"erse and therefore the $alancein deferred ta+es will continue to (row and not $ecome paya$le. This meansthat the lon(%term de$t ratio of a company would $e ad"ersely affected if deferred ta+es are considered lon(%term de$t 2first "iewpoint4N howe"er* thisratio would $e fa"ora$ly impacted if such ta+es are considered as part of shareholders& e!uity 2second "iewpoint4.

10-43


44/58

?.@7 P1BP7 000PA 000

P1*000P1*000P1BP7*000P@*000P1B*000dc(

eca



a. Ratio Computations

1. :ear P*700a H P10*000$ Q 0. :ear B PD7*B00a H P1?D*000$ Q 0.B0

aIncludes 214 Total current lia$ilities*274 #on(%term de$t due after one year* and2?4 6eferred income ta+es

$Includes 214 All items in 2a4 a$o"e* as well as274 inority interest* and2?4 ,toc'holders& e!uity

7. :ear P*700 H P@*000 Q 1.77 :ear B PD7*B00 H P@*000 Q 1.?

?. :ear P1*700a H P@*D00$ Q .?B

:ear B P7D*B00a H P*@00$ Q .7aIncludin( deferred ta+es.$,toc'holders& e!uity S minority interest.

@. :ear

M #oss per income statement 2additional ?00 added $ac' in ,C5 represents di"idendsrecei"ed4.

:ear B

MM5rom the statement of cash flows 2income minus di"idends recei"ed4. a9re%ta+ income $Interest incurred % interest capitali8ed cAmorti8ation of $ond discount dInterest portion of operatin( rental e+pense eAmount of pre"iously capitali8ed interest amorti8ed in this period f

Re"ersal of undistri$uted income 2loss4 of associated companies (Interest incurred

10-44

7.B1 P70P7*A00PG*7D0

MMP1*@00%P1*700P70P7*A00PC*@70P71*000d( c

f edc$a


45/58



. Cash from operationsM S income ta+ e+pense 2e+cept deferred ta+es4S fi+edchar(esMM

5i+ed char(esMM

M 6epreciation added $ac' already includes amorti8ation of interest pre"iouslycapitali8ed.MMAs computed in 2@4 a$o"e.

:ear P*00 S 2P*D00%P1*0004 S P*01B H P*01B Q ?.0 :ear B PB*@00S2P10*000%P1*B004SP11*D00H P11*D00 Q 7.7

$. Analysis and Interpretation

The financial le"era(e inde+* which underwent only minimal chan(e* is at ale"el su((esti"e of le"era(e $enefits to XETA&s stoc'holders. There also has

$een a mar'ed increase in le"era(e as is indicated $y the total de$t to e!uityand the lon(%term de$t to e!uity measures. With total lia$ilities e+ceedin(e!uity $y o"er 0 percent* the le"el of lia$ilities is si(nificant. The relation of lon(%term de$t to e!uity is at a somewhat lower le"el. The earnin(s and cashflow co"era(e of fi+ed char(es are low on an a$solute $asis and ha"edeclined from :ear to :ear B. This decline is primarily $ecause fi+ed char(esincreased faster than net income. 5inally* operatin( cash flows declined in

:ear B compared to :ear .

10-45


46/58


9ro$lem 10%1B 2B0 minutes4

a. Ratios ased on 9rojected :ear 6ata

1. )peratin( income H ,ales Q D.DO.

7. Earnin(s $efore interest and ta+es H Total assets Q 7.GO.

?. Times interest earned Q Earnin(s $efore interest and ta+esH Interest Q 1.01.

@. #on(%term de$t H Total assets Q .O.

$. Effect of :ear er(er on the Ratios and Creditworthiness of RT

1. )peratin( income to sales The creditworthiness of RT Corporation* fromthe standpoint of operatin( profit mar(in* declines $ecause of the mer(er.)peratin( mar(ins for the com$ined company is wea'er $ecause of theina$ility to (enerate hi(her operatin( profits on the com$ined sales. ,till*this ratio should $e e"aluated o"er a lon(er term to determine whether theoperatin( efficiency of the company is impro"in(.

7. EITHTotal assets The return on assets ratio declines. The company


47/58


9ro$lem 10%1B-concluded

c. old or ,ell Analysis of RT onds $y Clayton Asset ana(ement

Currently* the RT $onds are tradin( as %rated $onds. 9rior to the mer(er*RT


48/58



Recommendation uy the 9atriot anufacturin( $onds.

3uantitati"e ,upport for Recommendation The ratio information shows that9atriot is less ris'y than ,turdy achines. 5irst* the pre%ta+ interest co"era(e of

,turdy achines is just o"er 1.0 "ersus 9atriot


49/58


CA,E,

Case 10%1 2G0 minutes4a.

5AL Corporation5orecasted ,tatement of Cash Receipts and 9ayments

5or :ear Ended 6ecem$er ?1* :ear 7

e(innin( cash$alanceUUUUUUUU

P ?0*000

Add Cash Receipts

e(innin( accountsrecei"a$leU.

P 7*000

S,ales for :ear 7 1UUUUUU.

1*10@*000

% Endin( accounts recei"a$le7... 27B*0004

CashcollectionsUUUUUUUU.

DD0*000

Total cashinflowsUUUUUUUUUU...

G10*000

6educt Cash dis$ursements

e(innin( accounts paya$leUU B0*000

S9urchases for :ear 7 ?UUU...

B00*000

%Endin( accounts paya$le @UU.

2*0004

9ayments tocreditorsUUUUU..

D*000

9ayments of cash e+penses U.

?1*G70

9ayment of notes paya$le 70*000

9ayment of lon(%termde$tUUU..

7*000

Total cash

dis$ursementsUUUUUUU.

G@*G70

/et cashflowUUUUUUUUUUUUU

P2?*G704

#ess minimum cash$alanceUUUUUU

270*0004

Cash $orrowin(s e+pectedUUUUU P2*G704

/otes

10-49


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1 ,ales for :ear 7 Q ,ales for :ear 1 + 11O Q PGB0*000 + 1.1 Q P1*10@*000

7 Endin( A.R. Q A"era(e daily sales + Collection periodQ P1*10@*000 + G0H?B0 Q P7B*000

? 9urchases 2:ear 74 Q C)K, S Endin

ch 10 - credit analysis

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