BWFF 5033

FINANCIAL REPORTING AND STATEMENT

ANALYSIS
CHAPTER 10:
CREDIT ANALYSIS ( LIQUIDITY )
PRESENTED BY:
MUSFIRAH MAZLAN 818112
YULFAIZAH MOHD YUSOFF 817158
NOR NASUHA AZIZAN 817259
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CONTENT
1)LIQUIDITY AND WORKING CAPITAL
2)OPERATING ACTIVITY ANALYSIS OF LIQUIDITY
3)ADDITIONAL LIQUIDITY MEASURES

PART I:
Liquidity and Working Capital

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LIQUIDTY
Ability to convert assets into cash or to obtain cash to
meet short-term obligations.
Short-term - Conventionally viewed as a period up
to one year.
Lack of liquidity can limit:

- Advantages of discounts
- Profitable opportunities
- Management actions
- Coverage of current obligations

Working Capital
1) Widely used measure of liquidity.
2) The excess of current assets over current liabilities.
3) Important due to following:a) As a measure of liquid assets that provide a safety
cushion to creditors
b) For measuring the liquid reserve available to meet
contingencies and the uncertainties surrounding a
companys balance of cash inflows and outflows.

CURRENT ASSETS
Cash and other assets
reasonably expected to
be :(1)realized in cash, or
(1)sold or consumed, during
the longer of one-year or
the operating cycle.

CURRENT LIABILITIES

Obligations expected to be
satisfied within a relatively
short period, usually a year.

TYPES

Working capital measure of liquidity

Current ratio measure of liquidity:

The current ratio is 3:1 ($300,000/$100,000) for Company A and 1.2:1
($1,200,000/$1,000,000) for Company B.
This ratio reveals a different picture for companies A and B. The ability to
differentiate between companies on the basis of liquidity helps account for the
widespread use of the current ratio.

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.

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.

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Net Trade Cycle

Analysis:

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Liquidity and Working Capital

Net Trade Cycle is computed as:

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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

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PART II:
Operating Activity Analysis of
Liquidity

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 Operating activity measures of liquidity are important in

credit analysis.
Operating analysis measures consists of three items which
is account receivable, inventory and current liabilities.

1) Account Receivable Liquidity Measures:

- for company selling on credit, accounts and notes
receivable are an important part of working capital.
-

in assessing liquidity, it is necessary to measure the quality

and liquidity of receivable where both are affected by their
turnover rate.

Accounts Receivable Liquidity Measures:

Accounts Receivable Turnover

Days Sales in Receivables

Receivables collection period

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Account receivable turnover

Example:

Consumer Electronic reports sales of $1200000, beginning receivable

of $150000 and year end receivables of $250000.
Account Receivable Turnover
= Net sales on credit
Avg. Account Receivable
=
$1200000
($150000 + $250000)/2
=
6#

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Days Sales in Receivables

Example:

Consumer Electronic reports sales of $1200000, beginning

receivable of $150000 and year end receivables of $250000.
Days Sales in Receivable
= Account Receivable / Sales
360
=
$250000
$1200000/360
=
75 days#

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.
Example: if usual credit term of sales are 40 days, then an average
collection period of 75 days is showing that
poor collection efforts
delay in customer payments
customer in financial distress

2) Inventory Turnover Measures:

-Inventories are investments made for purposes of obtaining
a return through sales to customers.

If inventory is inadequate, sales volume

declines below an attainable level.

Excessive inventory shows a company to

storage costs, insurance, taxes,
obsolescence and physical deterioration.
Funds can be used more profitable
elsewhere.

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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:

Shows the number of days required to sell ending inventory

An alternative measure - Days to sell inventory ratio:

Example:
(Days Sales in Inventory)
Financial information from Macon Resources for Year 8:
Sales. $1800000
Cost of Goods Sold $1200000
Beginning inventory.... $200000
Ending inventory. $400000
Days Sales in Inventory
= Inventories / Cost of Goods Sold
360
=
400000
$1200000/360
=
120 days#
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Interpreting Inventory
Turnover
Quality of inventory: refer to a companys ability to use and dispose of
inventory. (basically company does not use inventory for paying
current liabilities cuts into sales volume)
Decreasing inventory turnover
Analyze if decrease is due to inventory build up in anticipation of
sales increases, contractual commitments, increasing prices,
work stoppages, inventory shortages, or other legitimate reason.
Effective inventory management increases inventory turnover.

Operating Activity Analysis

of Liquidity
Interpreting Inventory
Turnover:

Conversion period or
operating cycle where
combines the collection of
receivables with the days to
sell inventories to obtain the
time interval to convert
inventories to cash.

It takes 195 days for a company to both

sell its inventory and to collect the
receivables based on current levels of
receivables and inventories.

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Operating Activity Analysis

of Liquidity

3) Liquidity of Current Liabilities:

- CL are important in computing both working capital and the current ratio
i) to determine whether the excess of current assets over current
liabilities affords a sufficient margin of safety.
ii) CL are deducted from current assets in arriving at working capital.
- Quality of CL
i) Must be judged on their degree of urgency in payment
Ii) Must be aware of unrecorded liabilities having a claim on current
funds

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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.

PART III:
Additional Liquidity Measures

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Current Assets Composition:

Indicator of Working Capital Liquidity

Example :

Additional Liquidity Measures

Acid Test Quick Ratio A more stringent test of liquidity

Cash + Cash Equivalents + Marketable Securities + Account
Receivables
Current Liabilities

Cash Flow Measures

- Cash Flow Ratio
Operating Cash Flow
Current Liabilities

- Overcomes the static nature of the current ratio since its

numerator reflects a flow variable

Additional Liquidity Measures

Financial Flexibility
- Ability to take steps to counter unexpected interruptions in the flow of
To borrow from various sources
To raise equity capital
To sell and redeploy assets
To adjust the direction level of operations

Managements Discussion and Analysis

- MD&A requires a discussion of liquidity
Known Trends
Demands
Commitments
Uncertainty

funds

Basics of Solvency
Solvency long run financial viability and its ability to cover long
term obligation
Capital Structure Financing sources and their attribute
Earning Power Recurring ability to generate income from
operation
Loan Covenants Protection against insolvency and financial
distress

Capital Structure

Equity financing
Risk capital of a company
Uncertain and unspecified return
Lack of any repayment pattern
Contributes to a companys stability
and solvency

Debt financing
Must be repaid with interest
Specified repayment pattern

When the proportion of debt financing is

higher, the higher are the resulting fixed
charges and repayment commitments

Basics of Solvency
Capital Structure Ratio:

Total Debt to Total Capital Ratio

Comprehensive measure of the relation between total debt and total capital
Also called Total debt ratio

Total Debt to Equity Capital

Long-Term Debt to Equity Capital

Measures the relation of LT debt to equity capital.
Commonly referred to as the debt to equity ratio.
Short-Term Debt to Total Debt

Indicator of enterprise reliance on short-term financing.

Usually subject to frequent changes in interest rates.

Basics of Solvency

Earning Power:
Earnings power measures provide insight into the ability of a
company to meet its fixed charges
High correlation between earnings-power measures and default
rate on debt
Earnings variability and persistence is important
Use earnings before discontinued operations, extraordinary
items, and cumulative effects of accounting changes for single
year analysis but, include them in computing the average
coverage ratio over several years

Basics of Solvency

Earning to Fixed Charges:

Limitation of capital structure measures - inability to focus on
availability of cash flows to service debt.
Role of earnings coverage, or earning power, as the source of
interest and principal repayments.
Earnings to fixed charges ratio

Time Interest Earned Ratio:

Considers interest as the only fixed charge needing earnings
coverage:

Numerator sometimes referred to as earnings before interest

and taxes, or EBIT.
Potentially misleading and not as effective an analysis tool as
the earnings to fixed charges ratio.

Cash Flow to Fixed Charge Ratio:

Computed using cash from operations rather than

earnings in the numerator of the earnings to fixed
charges ratio.

Basics of Solvency

Earning Power of Preferred Dividends Ratio:

Computation must include in fixed charges all expenditures
taking precedence over preferred dividends.
Since preferred dividends are not tax deductible, after-tax
income must be used to cover them.

THANK YOU
12/17/15