10-1

Credit Analysis

10

CHAPTER

10-2

Liquidity and Working Capital

Basics
Liquidity
Liquidity--Ability
Abilityto
toconvert
convertassets
assetsinto
intocash
cashor
orto
toobtain
obtain
cash
cashto
tomeet
meetshort-term
short-termobligations.
obligations.
Short-term
Short-term--Conventionally
Conventionallyviewed
viewedas
asaaperiod
periodup
upto
to
one
oneyear.
year.
Working
WorkingCapital
Capital--The
Theexcess
excessof
ofcurrent
currentassets
assetsover
over
current
currentliabilities.
liabilities.

10-3

Liquidity and Working Capital

Basics

Current Assets - Cash and other assets reasonably expected to

be (1) realized in cash, or (2) sold or consumed, during the longer
of one-year or the operating cycle.
Current liabilities - Obligations to be satisfied within a relatively
short period, usually a year.
Working Capital - Excess of current assets over current liabilities
Widely used measure of short-term liquidity
Constraint for technical default in many debt agreements

Current Ratio Ratio of Current Assets to Current Liabilities

Relevant measure of current liability coverage, buffer against losses,
reserve of liquid funds.
Limitations A static measure

10-4

Liquidity and Working Capital

Current Ratio
Numerator Considerations
Adjustments needed to counter limitations such as:

Failure to reflect open lines of credit

Adjust securities valuation since the balance sheet date
Reflect revolving nature of accounts receivable
Recognize profit margin in inventory
Adjust inventory values to market
Remove deferred charges of dubious liquidity from prepaid
expenses

Denominator Considerations
Payables vary with sales.
Current liabilities do not include prospective cash outlays.

10-5

Liquidity and Working Capital

Current Ratio
Liquidity depends to a large extent on prospective cash
flows and to a lesser extent on the level of cash and
cash equivalents.
No direct relation between balances of working capital
accounts and likely patterns of future cash flows.
Managerial policies regarding receivables and
inventories are directed primarily at efficient and
profitable asset utilization and secondarily at liquidity.
Two elements integral to the use of current ratio:
Quality of both current assets and current liabilities.
Turnover rate of both current assets and current liabilities.

10-6

Liquidity and Working Capital

Current Ratio - Applications
Comparative Analysis
Trend analysis

Ratio Management (window dressing)

Toward close of a period, management will occasionally press the
collection of receivables, reduce inventory below normal levels, and
delay normal purchases.

Rule of Thumb Analysis (2:1)

Current ratio above 2:1 - superior coverage of current liabilities (but not
too high - inefficient resource use and reduced returns)
Current ratio below 2:1 - deficient coverage of current liabilities

Note of caution
Quality of current assets and the composition of current liabilities are
more important in evaluating the current ratio.
Working capital requirements vary with industry conditions and the
length of a companys net trade cycle.

Liquidity and Working Capital

Current Ratio - Applications

Net Trade Cycle Analysis

10-7

10-8

Liquidity and Working Capital

Cash-Based Ratio Measures of Liquidity
Cash to Current Assets Ratio
Cash + Cash equivalents + Marketable securities
Current Assets

Larger the ratio, the more liquid are current assets

Cash to Current Liabilities Ratio

Cash + Cash equivalents + Marketable securities
Current Liabilities

Larger the ratio, the more cash available to pay current

obligations

10-9

Operating Activity Analysis of Liquidity

Accounts Receivable Liquidity Measures

Accounts Receivable Turnover

Days Sales in Receivables

Receivables collection period

10-10

Operating Activity Analysis of Liquidity

Interpretation of Receivables Liquidity Measures

Accounts receivable turnover rates and

collection periods are usefully compared with
industry averages or with credit terms.
Ratio Calculation: Gross or Net?
Trend Analysis
Collection period over time.
Observing the relation between the provision for
doubtful accounts and gross accounts receivable.

10-11

Operating Activity Analysis of Liquidity

Inventory Turnover Measures
Inventory turnover ratio:
Measures the average rate of speed at which inventories
move through and out of a company.

Days Sales in Inventory:

Illustration (Days sales in inventory)

Shows the number of days required to sell ending inventory

An alternative measure - Days to sell inventory ratio:

10-12

Operating Activity Analysis of Liquidity

Interpreting Inventory Turnover
Quality of inventory
Decreasing inventory turnover
Analyze if decrease is due to inventory buildup in
anticipation of sales increases, contractual commitments,
increasing prices, work stoppages, inventory shortages, or
other legitimate reason.

Inventory management
Effective inventory management increases inventory
turnover.

10-13

Operating Activity Analysis of Liquidity

Interpreting Inventory Turnover
Conversion period or
operating cycle:

Measure of the speed

with which inventory is
converted to cash

10-14

Operating Activity Analysis of Liquidity

Liquidity of Current Liabilities
Current liabilities are important in computing working
capital and current ratio:
Used in determining whether sufficient margin of safety exists.
Deducted from current assets in arriving at working capital.

Quality of Current Liabilities

Must be judged on their degree of urgency in payment
Must be aware of unrecorded liabilities having a claim on
current funds

10-15

Operating Activity Analysis of Liquidity

Days Purchases in Accounts Payable

Days Purchases in Accounts Payable

Measures the extent accounts payable represent
current and not overdue obligations.

Accounts Payable Turnover

Indicates the speed at which a company pays for
purchases on account.

10-16

Additional Liquidity Measures

Current Assets Composition
Indicator of working capital liquidity
Illustration

10-17

Additional Liquidity Measures

Acid-Test (Quick) Ratio - A more stringent test of
liquidity

Cash Flow Measures

Cash Flow Ratio

Overcomes the static nature of the current ratio since its

numerator reflects a flow variable.

10-18

Additional Liquidity Measures

Financial Flexibility - Ability to take steps to counter
unexpected interruptions in the flow of funds.
Ability to borrow from various sources; to raise equity capital; to
sell and redeploy assets; to adjust the level and direction of
operations to meet changing circumstances; levels of
prearranged financing and open lines of credit

Managements Discussion and Analysis

MD&A requires a discussion of liquidity
including known trends, demands, commitments,
or uncertainties likely to impact the companys
ability to generate adequate cash.

10-19

Additional Liquidity Measures

What-if analysis

Technique to trace through the effects of

changes in conditions/ policies on cash
resources of a company

10-20

Additional Liquidity Measures

What-if analysis Illustration
Background DataConsolidated Technologies at December 31, Year 1:
Cash
Accounts receivable
Inventory
Accounts payable
Notes payable
Accrued taxes
Fixed assets
Accumulated depreciation
Capital stock

$ 70,000
150,000
65,000
130,000
35,000
18,000
200,000
43,000
200,000

The following additional information is reported for Year 1:

Sales
Cost of sales
Purchases
Depreciation
Net income

$750,000
520,000
350,000
25,000
20,000

Anticipates 10 percent growth in sales for Year 2

All revenue and expense items are expected to increase by 10 percent, except for depreciation,
which remains the same
All expenses are paid in cash as they are incurred
Year 2 ending inventory is projected at $150,000
By the end of Year 2, predicts notes payable of $50,000 and a zero balance in accrued taxes
Maintains a minimum cash balance of $50,000

10-21

Additional Liquidity Measures

What-if analysis - Illustration
Case 1: Consolidated Technologies is considering a change in credit policy where ending accounts
receivable reflect 90 days of sales. What impact does this change have on the companys cash
balance? Will this change affect the companys need to borrow?
Our analysis of this what-if situation is as follows:
Cash, January 1, Year 2
Cash collections:
Accounts receivable, January 1, Year 2
Sales
Total potential cash collections
Less: Accounts receivable, December 31, Year 2
Total cash available
Cash disbursements:
Accounts payable, January 1, Year 2
$ 130,000
Purchases
657,000(b)
Total potential cash disbursements
$ 787,000
Accounts payable, December 31, Year 2
( 244,000)(c)
Notes payable, January 1, Year 2
$ 35,000
Notes payable, December 31, Year 2
( 50,000)
Accrued taxes
Cash expenses(d)
Cash, December 31, Year 2
Cash balance desired
Cash excess

$ 70,000
$ 150,000
825,000
$ 975,000
( 206,250)(a)

768,750
$ 838,750

$ 543,000
(15,000)
18,000
203,500

749,500
$ 89,250
50,000
$ 39,250

(continued)

10-22

Additional Liquidity Measures

What-if analysis - Illustration
Explanations:
(a)

(b)Year 2 cost of sales*: $520,000 1.1 = $

Ending inventory (given)
Goods available for sale
$
Beginning inventory
Purchases
$
* Excluding depreciation.
(c)

572,000
150,000
722,000
(65,000)
657,000

(d) Gross profit ($825,000 $572,000)

$253,000
Less: Net income
$ 24,500*
Depreciation
25,000
( 49,500)
Other cash expenses
$203,500
*110 percent of $20,000 (Year 1 N.I.) + 10 percent of $ 25,000 (Year 1 depreciation).