Credit Analysis

Liquidity

  • the ability to convert assets into cash to meet short-term obligations
  • lack of liquidity prevents a company from taking advantage of favorable discounts or profitable opportunities

Current Assets and Liabilities

Common concerns

  1. Contingent liabilities associated with loan guarantees
  2. Future minimum rental payments
  3. Contracts for construction or acquisition of long-term assets

Current Ratio as a Measure of Liquidity

Relevance

  1. Current liability coverage
  2. Buffer against losses
  3. Reserve of liquid funds

Limitations

  1. Unable to predict pattern of future cash inflows and outflows
  2. Unable to measure the adequacy of future cash inflows to outflows

Operating Activity Analysis of Liquidity

Accounts Receivable Turnover

Inventory Turnover

Capital Structure and Solvency

  • Long-term time horizon unlike short-term liquidity analysis
  • Capital structure, sources of financing for a company
  • Sustainable earning power, recurring ability to generate cash from operations

Characteristics of Debt and Equity

  • Equity, risk capital, uncertain returns, contributes to stability, high degree of permanence
  • Debt, must be repaid
  • Financial leverage, use of debt to increase earnings, magnifies both income or losses

Motivation for Debt Capital

  1. Provided interest cost is less than return on net operating assets, excess return is to the benefit of equity investors
  2. Interest is a tax-deductible expense while dividend is not

Adjustments for Capital Structure Analysis

  1. Deferred income taxes
  2. Operating leases
  3. Off-balance-sheet financing
  4. Contingent liabilities
  5. Minority interests
  6. Convertible debt
  7. Preferred stock

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