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
o is a firms ability to meet its current maturing obligations from available
cash or near cash resources (ability to generate cash from internal
operations)
o for assets describes how quickly an asset can be converted into cash and
the certainty associated with the conversion ratio or price
o 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
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 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
o represents a cushion or margin of protection for current creditors
o 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 nature

4. 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 sold
2. 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)
Method
Cost

Balance Sheet Reporting

Purchase Value (Cost)

Market

Market Value

LoCoM

Purchase or Market Value

(whichever is lower)
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Income Statement Reporting

Dividends Received
Realized Gain or Loss
Dividends Received
Realized & Unrealized Gain or Loss
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
Type

Held for
Trading
Availabl
e for
Sale
Held to
Maturity

Balance Sheet Reporting

Income Statement Reporting

Dividends Received
Realized Gain or Loss
Unrealized Loss or Recovery
Dividends Received
Realized Gain or Loss

Market Method
Market Method
Unrealized Gain or Loss in
Shareholders Equity

Dividends Received
Realized Gain or Loss

Cost Method

Illustrative Diagram
Investment

< 20%

20%-50%

> 50%

No Significant Control

Significant Control

Full Control

Traded

Equity Method

Consolidation

No

Yes

Cost Method

Trading

Available for Sale

Held to Maturity

 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
o is used when the investor exercises a significant control over the investment
o 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
o dividends received reduce the carrying value of the investment
o changes in the market value of the investment are not recognized under this
method unless there is a permanent impairment
o favorable results are reported in case the investment is a profitable one as
long as dividend payout is less than 100%
o interest coverage ratio & return ratios will improve
o the investor recognizes the proportionate share in investment income
without any recognition of its debt; therefore, leverage ratios improve
o 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
o Minority Interest equals the proportionate share of the minority in the
equity of the subsidiary less dividends paid
o Minority Interest should be considered as a long term liability when
calculating leverage ratios
Interest Expense
o Interest Rate = Interest Expense / Average Funded Debt
o changes in Interest Rate to Average Funded Debt indicate either changes in
the type of debt or average interest rate charges
o 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
o 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:
o Working Capital = Current Assets Current Liabilities
o Current Ratio = Current Assets / Current Liabilities
o 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

Formulas
Working 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 Worth

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

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

the lower the better

A/R Turnover

= (Average) CoGS / (Average) A/R

the higher the better

A/R DoH

= 365 / A/R Turnover

the 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 / Sales

the 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
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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

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 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 Expense

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Capital 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
o 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
o has priority over common dividend payments
Equity
o does not require contractual payments to equity holders
o in case there is no availability of cash to pay dividends, in case of
common stock, shareholders cannot force bankruptcy
o 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:

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o 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)
o Business Risk should be absorbed by equity holders
Permanent Level of Working Investment should be financed by Equity and/or
Long term Debt
Illustrative Diagram
Company
Short term Investment

Long term Investment

Working Investment

Long term Assets

Permanent Fund

Short term Debt

Equity

Short term Debt

Revolving
Long term Debt

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