Chapter 10 - Credit analysis. This chapter begins with additional tools for assessing short-term liquidity. We explain liquidity and describe analysis tools capturing different aspects of it. Attention is directed at accounting-based ratios, turnover, and operating activity measures of liquidity. This chapter also focuses on capital structure and its implications for solvency. We analyze the importance of financial leverage and its effects on risk and return. We also describe book values and earnings coverage measures and their interpretation. | Financial Statement Analysis . Subramanyam Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10 CHAPTER Credit Analysis Liquidity and Working Capital • Liquidity - 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. • Working Capital - The excess of current assets over current liabilities. Basics Liquidity and Working Capital 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 Basics Liquidity and Working Capital 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. Current Ratio Liquidity and Working Capital 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 . | Financial Statement Analysis . Subramanyam Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10 CHAPTER Credit Analysis Liquidity and Working Capital • Liquidity - 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. • Working Capital - The excess of current assets over current liabilities. Basics Liquidity and Working Capital 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 – .
