Credit Analysis

This chapter focuses on credit analysis. It is separated into two major sections: liquidity analysis and solvency analysis. Liquidity refers to the availability of resources to meet short-term cash requirements. A company's short-term liquidity risk is affected by the timing of cash inflows and outflows along with its prospects for future performance. Our analysis of liquidity is aimed at companies' operating activities, their ability to generate profits from the sale of goods and services, and working capital requirements and measures. This chapter describes several financial statement analysis tools to assess short-term liquidity risk for a company. We begin with a discussion of the importance of liquidity and its link to working capital. We explain and interpret useful ratios of both working capital and a company's operating cycle for assessing liquidity. We also discuss potential adjustments to these analysis tools and the underlying financial statement numbers. What-if analysis of changes in a company's conditions or strategies concludes this section.

The second part of this chapter considers solvency analysis. Solvency is an important factor in our analysis of a company's financial statements. Solvency refers to a company's long-run financial viability and its ability to cover long-term obligations. All business activities of a company—financing, investing, and operating—affect a company's solvency. One of the most important components of solvency analysis is the composition of a company's capital structure. Capital structure refers to a company's sources of financing and its economic attributes. This chapter describes capital structure and explains its importance to solvency analysis. Since solvency depends on success in operating activities, the chapter examines earnings and its ability to cover important and necessary company expenditures. Specifically, this chapter describes various tools of solvency analysis, including leverage measures, analytical accounting adjustments, capital structure analysis, and earnings-coverage measures. We demonstrate these analysis tools with data from financial statements. We also discuss the relation between risk and return inherent in a company's capital structure, and its implications for financial statement analysis.

 

Section 1:  Liquidity Liquidity and Working Capital  Current Assets and Liabilities Working Capital Measure of Liquidity Current Ratio Measure of Liquidity Using the Current Ratio for Analysis Cash Based Ratio Measures of Liquidity Operating Activity Analysis of Liquidity Accounts Receivable Liquidity Measures Inventory Turnover Measures Liquidity of Current Liabilities Additional Liquidity Measures Current Assets Composition Acid Test (Quick) Ratio Cash Flow Measures Financial Flexibility Management's Discussion and Analysis What If Analysis Section 2:  Capital Structure and Solvency Importance of Capital Structure Characteristics of Debt and Equity Motivation for Debt Capital Concepts of Financial Leverage Adjustments for Capital Structure Analysis Capital Structure Composition and Solvency Common-Size Statements in Solvency Analysis Capital Structure Measures for Solvency Analysis Interpretation of Capital Structure Measures            Asset-Based Measures of Solvency Earnings Coverage Relation of Earnings to Fixed Charges Times Interest Earned Analysis Relation of Cash Flow to Fixed Charges Earnings Coverage of Preferred Dividends Interpreting Earnings Coverage Measures Capital Structure Risk and Return Appendix 11A:  Rating Debt Appendix 11B:  Predicting Financial Distress

Explain the importance of liquidity in analyzing business activities. Describe working capital measures of liquidity and their components.   Interpret the current ratio and cash-based measures of liquidity. Analyze operating cycle and turnover measures of liquidity and their interpretation.   Illustrate what-if analysis for evaluating changes in company conditions and policies. Describe capital structure and its relation to solvency.   Explain financial leverage and its implications for company performance and analysis. Analyze adjustments to accounting book values to assess capital structure.   Describe analysis tools for evaluating and interpreting capital structure composition and for assessing solvency. Analyze asset composition and coverage for solvency analysis.   Explain earnings-coverage analysis and its relevance in evaluating solvency. Describe capital structure risk and return and its relevance to financial statement analysis.   Interpret ratings of organizations' debt obligations (Appendix 11A). Describe prediction models of financial distress (Appendix 11B).

 

1.   Liquidity is an indicator of an entity's ability to meet its current obligations. An entity in a weak short term liquidity position will have difficulty in meeting short term obligations. This has implications for any current and potential stakeholders of a company. For example, lack of liquidity would affect users’ analysis of financial statements in the following ways:
Equity investor: In this case, the company likely is unable to avail itself of favorable discounts and to take advantage of profitable business opportunities. It could even mean loss of control and eventual partial or total loss of capital investment.
Creditors: In this case, delay in collection of interest and principal due would be expected and there is a possibility of the partial or total loss of the amounts due them.

2.   A major limitation in using working capital (in dollars) as an analysis measure is its failure to meaningfully relate it to other measure for interpretive purposes. That is, working capital is much more meaningful when related to other amounts, such as current liabilities or total assets.  In addition, the importance attached to working capital by various users provides a strong incentive for an entity (especially the ones in a weak financial position) to stretch the definition of its components.  For example, some managers may “expand” the definition of what constitutes a current asset and a current liability to better present their current position in the most favorable light. Moreover, there are several opportunities for managers to stretch these definitions. For this reason, the analyst must use judgment in evaluating management’s classification of items included in working capital—and apply adjustments when necessary.

3.   In classification of accounts as current or noncurrent, we look to both the intentions of management and the normal practice for the industry (beyond the “longer of the operating cycle or one-year” rule). In the case of fixed assets, there is the possibility of their inclusion in current assets under one condition. The condition is that management intends to sell these fixed assets and management has a definite contractual commitment from a buyer to purchase them at a specific price within the following year (or operating cycle, if longer).

4.   Installment receivables derived from sales in the regular course of business are deemed to be collectible within the operating cycle of a company. Therefore, such installment receivables are to be included in current assets.

5.   Inventories are not always reported as current assets. Specifically, inventory amounts in excess of current requirements should be excluded from current assets. Current requirements include quantities to be used within one-year or the normal operating cycle, whichever period is longer. Business at times builds up its inventory in excess of current requirement to hedge against an increase in price or in anticipation of a strike. Such excess inventories beyond the requirements of one year should be classified as noncurrent.

6.   Prepaid expenses represent advance payments for services and supplies that would otherwise require the current outlay of funds during the succeeding one-year or a longer operating cycle.

7.   Banks usually reserve the right not to renew the whole or part of a loan at their option when they sign a revolving loan agreement. The fact that a bank agrees informally to renew short term notes does not make them noncurrent. The possibility that the company under analysis included such notes under long term liabilities should be carefully assessed (and potentially reclassified if our analysis suggests otherwise).

8.   Some of these industry characteristics, such as the absence of any distinction between current and noncurrent on the balance sheet in the real estate industry, can indeed require special treatment. However, even in such cases, analysts should be careful to consider whether these "special" characteristics change the relation existing between current obligations and the liquid funds available (or reasonably expected to become available) to meet them. Our analysis should adjust the classifications of any items not meeting our assessment of the current and noncurrent criteria.

9.     Identical working capital does not imply identical liquidity. The absolute amount of working capital has significance only when related to other variables such as sales, total assets, etc. The absolute amount only has, at best, a limited value for intercompany comparisons. A better gauge of liquidity when focusing on working capital is to relate its amount to either or both of current assets and current liabilities (or sales, assets, etc.).

10.   The current ratio is the ratio of current assets to current liabilities. It is a static measure of resources available at a given point in time to meet current obligations. The reasons for its widespread use include:

• It measures the degree to which current assets cover current liabilities.
• It measures the margin of safety available to allow for possible shrinkage in the value of current assets.
• It measures the margin of safety available to meet the uncertainties and the random shocks to which the flows of funds in a company are subject.

11.   Cash inflows and cash outflows are not perfectly predictable. For example, in the case of a business downturn, sales can decline more rapidly than do outlays for purchases and expenses. The amount of cash held is in the nature of a precautionary reserve, which is intended to take care of short term surprises in cash inflows and outflows.

12.   There is a relation between inventories and sales. Specifically, as sales increase (decrease), the inventory level typically increases (decreases). However, inventories are a direct function of sales only in rare cases. Methods of inventory management exist, and experience suggests that inventory increments vary not in proportion to demand (sales) but rather with measure approximating the square root of demand.

13.   Management’s major objectives in determining the amounts invested in receivables and inventories include the promotion of sales, improved profitability, and the efficient utilization of assets.

14.   The current ratio is a static measure. The value of the current ratio as a measure of liquidity is limited for the following reasons:

• Future liquidity depends on prospective cash flows and the current ratio alone does not indicate what these future cash flows will be.
• There is no direct or established relationship between balances of working capital items and the pattern which future cash flows are likely to assume.

• Managerial policies directed at optimizing the levels of receivables and inventories are oriented primarily toward the efficient and profitable utilization of assets and only secondarily at liquidity considerations.

15.   The limitations to which the current ratio is subject should be recognized and its use should be restricted to the type of analytical task it is capable of serving. Specifically, the current ratio can help assess the adequacy of current assets to discharge current liabilities. This implies that any excess (called working capital) is a liquid surplus available to meet imbalances in the flow of funds, shrinkage in value, and other contingencies.

16.   Cash-based ratios of liquidity typically refer to the ratio of cash (including cash equivalents) to total current assets or to total current liabilities. The choice of deflator depends on the purposes of analysis. (i) The higher the ratio of cash to total current assets the more liquid the current asset group is. This means that this portion of the total current assets is subject only to a minimal danger of loss in value in case of liquidation and that there is practically no waiting period for conversion of these assets into usable cash. (ii) The ratio of cash to total current liabilities measures how much cash and cash equivalents are available to immediately pay current obligations. This is a severe test that ignores the revolving nature of current liabilities. It supplements the cash ratio to total current assets in that it measures cash availability from a somewhat different point of view.

17.   An important measure of the quality of current assets such as receivables and inventories is their turnover. The faster the turnover—collections in case of receivables and sales in case of inventories—the smaller the likelihood of loss on ultimate realization of these assets.

18.   The average accounts receivable turnover measures in effect the speed of their collection during the period. The higher the turnover figure, the faster the collections are, on average.

19.   The collection period (or days' sales in accounts receivable) measures the number of days' sales uncollected. It can be compared to a company's credit terms to evaluate the quality of its collection activities.

20.   Either one or all of the following are possible reasons for an increase in the collection period:

• A relatively poorer collection job.
• Difficulty in obtaining prompt payment for various reasons from customers in spite of diligent collection efforts.
• Customers in financial difficulty, which in turn may imply a poor job by the credit department.
• Change of credit policies or sales terms in a desire to increase sales.
• Excessive delinquency of one or a few substantial customers.

21.   (a) If the inventory level is inadequate, the sales volume may decline to below the level of sales otherwise attainable. A loss of potential customers can also occur. (b) Excessive inventories, however, expose the company to expenses such as storage costs, insurance, and taxes as well as to risks of loss of value through obsolescence and physical deterioration. Excessive inventories also tie up funds that can be used more profitably elsewhere.

22.   The LIFO method of inventory valuation in times of increasing costs can render both the inventory turnover ratio as well as the current ratio practically meaningless. However, there is information regarding the LIFO reserve that is reported in financial statements. Use of the LIFO reserve enables the analyst to adjust an unrealistically low LIFO inventory value to a more meaningful inventory amount. Still, in intercompany comparative analysis, even if two companies use LIFO cost methods for their inventory valuations, the ratios based on such inventory figures may not be comparable because their respective LIFO inventory pools (bases) may have been acquired in years of significantly different price levels.

23.   The composition of current liabilities is important because not all current liabilities represent equally urgent and forceful calls for payment. Some claims, such as for taxes and wages, must be paid promptly regardless of current financial difficulties. Others, such as trade bills and loans, usually do not represent equally urgent calls for payment.

24.   Changes in the current ratio over time do not automatically imply changes in liquidity or operating results. In a prosperous year, growing liabilities for taxes can result in a lowering of the current ratio. Moreover, in times of business expansion, working capital requirements can increase with a resulting contraction of the current ratio—so-called "prosperity squeeze." Conversely, during a business contraction, current liabilities may be paid off while there is a concurrent (involuntary) accumulation of inventories and uncollected receivables causing the ratio to rise. Finally, advances in inventory practices (such as just-in-time) can lower the current ratio.

25.   "Window dressing" refers to the adjustment of year end account balances of current assets and liabilities to show a more favorable current ratio than is otherwise warranted. This can be accomplished, for example, by temporarily stepping up the efforts for collection, by temporarily recalling advances and loans to officers, and by reducing inventory to below the normal level and use the proceeds from these steps to pay off current liabilities. The analyst should go beyond year end reported amounts and try to obtain as many interim readings of the current ratio as possible. Even if the year end current ratio is very strong, interim ratios may reveal that the company is dangerously close to insolvency. More generally, our analysis must always be aware of the possibility of window dressing of both current and noncurrent accounts.

26.   The rule of thumb regarding the current ratio is 2:1 — a value below that level suggests serious liquidity risk. Also, the rule of thumb suggests that the higher the current ratio be above the 2:1 level, the better. The following points, however, should be kept in mind so as not to expose our analysis to undue risks of errors in inferences:

• A current ratio much higher than 2 to 1, while implying a superior coverage of current liabilities, can signal a wasteful accumulation of liquid resources.
• It is the quality of the current assets and the nature of the current liabilities that are more significant in interpreting the current ratio—not simply the level itself.

• The need of a company for working capital varies with industry conditions as well as with the length of its own net trade cycle.

27.   In an assessment of the overall liquidity of a company’s current assets, the trend of sales is an important factor. Since it takes sales to convert inventory into receivables and/or cash, an uptrend in sales indicates that the conversion of inventories into more liquid assets will be easier to achieve than when sales remain constant. Declining sales, on the other hand, will retard the conversion of inventories into cash and, consequently, impair a company’s liquidity.

28.   In addition to the tools of analysis of short term liquidity that lend themselves to quantification, there are important qualitative considerations that bear on short term liquidity. These can be usefully characterized as depending on the financial flexibility of a company. Financial flexibility is the ability of a company to take steps to counter unexpected interruptions in the flow of funds. This refers to the ability to borrow from a variety of sources, to raise equity capital, to sell and redeploy assets, and to adjust the level and direction of operations to meet changing circumstances. The capacity to borrow depends on numerous factors and is subject to rapid change. It depends on profitability, stability, relative size, industry position, asset composition and capital structure. It will depend, moreover, on such external factors as credit market conditions and trends. The capacity to borrow is important as a source of funds in a time of need and is also important when a company must roll over its short term debt. Prearranged financing or open lines of credit are more reliable sources of funds in time of need than is potential financing. Other factors which bear on the assessment of the financial flexibility of a company are the ratings of its commercial paper, bonds and preferred stock, restrictions on the sale of its assets, the degree of discretion with its expenses as well as the ability to respond quickly to changing conditions such as strikes, shrinking demand, and cessation of supply sources.

        The SEC requires a "Management's Discussion and Analysis of Financial Condition and Results of Operations" (MD&A). This requirement includes a discussion of liquidity factors—including known trends, demands, commitments or uncertainties likely to have a material impact on the company's ability to generate adequate amounts of cash. If a material deficiency in liquidity is identified, management must discuss the course of action it has taken or proposes to take to remedy the deficiency. In addition, internal and external sources of liquidity as well as any material unused sources of liquid assets must be identified and described.

29.   The importance of projecting the effects of changes in conditions and policies on the cash resources of a company is to allow for proper planning and control. For example, if management decides to ease the credit terms to its customers, knowing the impact of the new policy on cash resources will help it make a more informed decision. It may seek improved terms from suppliers or make arrangements to obtain a loan.

30. Key elements in evaluating long term solvency are:

• Analysis of the capital structure of the firm.
• Assessing different risks for different types of assets.
• Measuring earnings, earning power, and earnings trend.
• Estimating earnings coverage of fixed charges.
• Assessing the asset coverage of loans.
• Measuring protection afforded by loan covenants and collateral agreements.

31. Analysis of capital structure is important because the financial stability of a company and the risk of insolvency depend on the financing sources as well as on the type of assets it holds and the relative magnitude of such asset categories. Specifically, there are essential differences between debt and equity, which are the two major sources of funds. Equity capital has no guaranteed return that must be paid out and there is no timetable for repayment of the capital investment. From the viewpoint of a company, equity capital is permanent and can be counted on to remain invested even in times of adversity. Therefore, the company can confidently invest equity funds in long term assets and expose them to the greatest risks. On the other hand, debts are expected to be paid at certain specified times regardless of a company's financial condition. To the investor in common stock, the existence of debt contains a risk of loss of investment. The creditors would want as large a capital base as is possible as a cushion that will shield them against losses that can result from adversity. Therefore, it is important for the financial analyst to review carefully all the elements of the capital structure.

32. Financial leverage is the result of borrowing and incurring fixed obligations for interest and principal payments. The owners of a successful business that requires funds may not want to dilute their ownership of the business by issuing additional equity. Instead, they can "trade on the equity" by borrowing the funds required, using their equity capital as a borrowing base. Financial leverage is advantageous when the rate of return on total assets exceeds the net after-tax interest cost paid on debt. An additional advantage provided by financial leverage is that interest expense is tax deductible while dividend payments are not.

33. Leverage is a two edged sword. In good times, net income benefit from leverage. In a recession or when unexpected adverse events occur, net income can be harmed by leverage. Therefore, the use of leverage is acceptable to the financial markets only up to some undefined level. Ninety percent is higher than that “acceptable” level. Specifically, at 90 percent debt to total capital, future financing flexibility would be extremely limited, lenders would not loan money, and equity financing may cost more than the potential returns on incremental investments. Also, a 90 percent debt level would make net earnings extremely volatile, with a sizable increase in fixed charges. The incremental cost of borrowing, including refunding of maturing issues, increases with the level of borrowing. A 90 percent debt level could pose the probability of default and receivership in the event that something goes wrong. The financial risk of such a company would be much too high for either stockholders or bondholders.

34. In an analysis of deferred income taxes, the analyst must recognize that under normal circumstances the deferred tax liabilities will “reverse” (become payable) only when a firm shrinks in size. Shrinkage in firm size is usually accompanied with losses instead of with taxable income. In such circumstances, the “drawing down” of the deferred tax account is more likely to involve credits to tax loss carryforwards or carrybacks, rather than to the cash account. To the extent that a future reversal is only a remote possibility, the deferred credit should be viewed as a source of long-term funding and be classifiable as part of equity. On the other hand, if the possibility of a drawing down of the deferred tax account in the foreseeable future is high, then the account, or a portion of it, is more in the nature of a long term liability.

35. The accounting requirements for the capitalization of leases are not rigorous and definite enough to insure that all leases that represent, in effect, installment purchases of assets are capitalized. Consequently, the analyst must evaluate leases that have not been capitalized with a view to including them among debt obligations. Leases which cover most (say 75 80 percent) of the useful life of an asset can generally be considered the equivalent of debt financing. (See Chapter 3 for additional analysis and discussion.)

36. Off-balance-sheet financing are attempts by management to structure transactions in such a way as to exclude debt (and related assets) from the balance sheet. This is usually accomplished by emphasizing legal (accounting) form over substance. Examples of such transactions are take or pay contracts, certain sales of receivables, and inventory repurchase agreements.

37. Pension accounting recognizes that if the fair value of pension assets falls short of the accumulated pension benefit obligation, a liability for pensions exists. However, this liability normally does not take into consideration the projected benefit obligation that recognizes an estimate for future pay increases. When pension plans base their benefits on future pay formulas, the analysts, who judge such understatement as serious and who can estimate it, may want to adjust the pension liability for analysis purposes.

38. The preferred method of presenting the financial statements of a parent and its subsidiary is in consolidated format. This is also the preferred method from an analysis point of view. However, separate financial statements of the consolidated entities are necessary in some cases, such as when the utilization of assets of a subsidiary (such as an insurance company or a bank) is not subject to the full discretion of the parent. Information on unconsolidated subsidiaries is also important when bondholders of such subsidiaries must look only to a subsidiary’s assets as security. Moreover, bondholders of the parent company (particularly holding companies) may derive a significant portion of their fixed charge coverage from the dividends of the unconsolidated subsidiaries. Yet, in the event of the subsidiary's bankruptcy, the parent bondholders may be in a junior position to the bondholders of the subsidiary.

39. a.   Generally, the minority interest is shown among liabilities in consolidated financial statements. However, the minority interest differs from debt in that it has neither mandatory dividend payment requirements nor principal repayment requirements. Therefore, for the purpose of capital structure analysis, it may be classified as equity rather than as a liability.
b.   The purpose of appropriating retained earnings is to "set aside" a certain portion of retained earnings to prevent them from serving as a basis for the declaration of dividends. There exists no claim by an outsider to such an appropriation until the contingency materializes. Therefore, unless the reason for the amount reserved is certain to occur, such appropriations should be considered a part of equity capital.
c.   A guarantee for product performance is the result of a definite contract with the buyer that commits the entity to correct product defects. Therefore, it is a potential liability and should be classified as such.
d.   Convertible debt is generally classified among liabilities. However, if the terms of conversion and the market price of the common stock are such that it is most likely to be converted into common stock, it should be considered as equity for the purpose of capital structure analysis.

e.   Most preferred stock entails no absolute obligation for payment of dividends or repayment of principal—that is, it possesses characteristics of equity. However, preferred stock with a fixed maturity or subject to sinking fund requirements should, from an analysis point of view, be considered as debt.

40. a.   The equity of a company is measured by the excess of total assets over total liabilities. Accordingly, any analytical revision of asset book values (from amounts reported at in the financial statements) yields a change in the amount of equity. For this reason, in assessing capital structure, the analyst must decide whether or not the book value amounts of assets are realistically stated in light of analysis objectives.

b.   The following are examples of the need for possible adjustments. Different or additional adjustments may be needed depending on circumstances: (1) Inventories carried at LIFO are generally understated in times of rising prices. The amount by which inventories computed under FIFO (which are closer to replacement cost) exceed inventories computed under LIFO is disclosed as the LIFO reserve. These disclosures should enable the analyst to adjust inventory amounts and the corresponding equity amounts to more realistic current costs.  (2) For fiscal years beginning before 12/16/93, marketable securities were generally stated at cost, which may be below market value. Using parenthetical or footnote information, the analyst can make an analytical adjustment increasing this asset to market value and increasing owner's equity by an equal amount.  (3) Intangible assets and deferred items of dubious value, which are included on the asset side of the balance sheet, have an effect on the computation of the total equity of a company. To the extent that the analyst cannot evaluate or form an opinion on the present value or future utility of such assets, they may be excluded from consideration, thereby reducing the amount of equity by the amounts at which such assets are carried. However, the arbitrary exclusion of all intangible assets from the capital base is an unjustified exercise in over-conservatism.

41. Long term creditors are interested in the future operations and cash flows of a debtor (in addition to the short term financial condition of the debtor). For example, a creditor of a three year loan would want to make an analysis of solvency assuming the worst set of economic and operating conditions. For such purposes, an analysis of short term liquidity is usually not adequate. However, such a dynamic analysis for the long term is subject to substantial uncertainties and requires assumptions for a much longer time horizon. The inevitable lack of detail and the uncertainties inherent in long term projections severely limit their reliability. This does not mean that long term projections are not useful. What it does mean is that the analyst must be aware of the serious limitations to which they are subject.

42. Common size analysis focuses on the composition of the funds that finance a company. As such, it reflects on the financial risk inherent in the capital structure. Specifically, it shows the relative magnitudes of the financing sources of the company and allows the analyst to compare them with similar data of other companies. Instead, capital structure ratios reflect on the financial risk of a company by relating various components of the capital structure to each other or to total financing. An advantage of ratio analysis is that it can be used as a screening device and, moreover, can reflect on relations across more than one financial statement.

43. The difference between the book value of equity capital and its market value is usually due to a number of factors. One of these is the effect of price level changes. These, in turn, are caused by at least two factors: change in the purchasing power of money and change in price due to economic factors such as the law of supply and demand. Therefore, with fluctuating prices, it is unlikely that historical cost will correspond to market value. Accounting methods in use can also significantly affect the book values of assets. For example, a particular depreciation method often is adopted for tax reasons rather than to measure the loss of value of an asset due to use or obsolescence. The analyst could potentially adjust for this distortion of current value by valuing the equity at market value. For actively traded securities this would not be too difficult. However, the stock market too is often subject to substantial overvaluation and undervaluation depending on the degree of speculative sentiment. Hence, in most cases, equity capital will not be adjusted to market—instead, the focus will be on valuing assets and liabilities, with equity as a residual value.

44. Since liabilities and equity reveal the financing sources of a company, and the asset side reveals the investment of these funds, we can generally establish direct relations between asset groups and selected items of capital structure. This does not, of course, imply that resources provided by certain liabilities or equity should be directly associated with the acquisition of certain assets. Still, it is valid to assume that the types of assets a company employs should determine to some extent the sources of resources used to finance them. Therefore, to help assess the risk exposure of a given capital structure, the analysis of asset distribution is one important dimension. As an example, if a company acquired long term assets by means of short term borrowings, the analyst would conclude that this particular method of financing involves a considerable degree of risk (and cost).

45. The earnings to fixed charges ratio measures directly the relation between debt related and other fixed charges and the earnings available to meet these charges. It is an evaluation of the ability of a company to meet its fixed charges out of current earnings. Earnings coverage ratios are superior to other tools, such as debt-to equity ratios, which do not focus on the availability of funds. This is because earnings coverage ratios directly measure the availability of funds for payment of fixed charges. Fixed charges are mainly a direct result of the incurrence of debt. An inability to pay their associated principal and interest payments represents the most serious risk consequence of debt.

46. Identifying the items to include in "fixed charges" depends on the purpose of the analysis. Fixed charges can be defined narrowly to include only interest and interest equivalents or broadly to include all outlays required under contractual obligations—specifically:
(a)  Interest and interest equivalents:

• Interest on long term debt (including amortization of any discounts and premiums).
• Interest element included in long term lease rentals.
• Capitalized interest.

(b) Other outlays under contractual obligations:

• Interest on income bonds (assuming profitable operations—implicit assumption in such borrowings).
• Required deposits to sinking funds and principal payments under serial bond obligations.
• Principal repayments included in lease obligations.

• Purchase commitments under noncancelable contracts to the extent that requirements exceed normal usage.
• Preferred stock dividend requirements of majority owned subsidiaries.
• Interest on recorded pension liabilities.
• Guarantees to pay fixed charges of unconsolidated subsidiaries if the requirement to honor the guarantee appears imminent.

(c)  Other fixed charges—such as imputed interest in the case on non interest or low interest bearing obligations. These are not periodical fund drains.

For each of the above categories, the corresponding income to be included in the ratio computation should be adjusted accordingly. Regarding fixed charges, those items not tax deductible must be tax adjusted. This is done by increasing them by an amount equal to the income tax that would be required to obtain an after tax income sufficient to cover the fixed charges. The tax rate to be used should be based on the relation of the taxes on income from continuing operations to the amount of pre-tax income from continuing operations—the company's effective tax rate.

47. A company normally signs a long term purchase contract to either insure that its supply of essential raw material is not interrupted or to get a favorable purchase discount, or both. In times of favorable economic conditions, the analyst need not worry about most such commitments (indeed, they are a positive factor). The only exception is when such commitments reflect amounts in excess of requirements given expected sales. Accordingly, if the analyst concludes that the purchase commitments represent the minimum required supplies, s/he can justifiably exclude the commitments from fixed charges. If the analyst includes the commitments in fixed charges, income should be adjusted to reflect the tax-deductible nature of the purchase that will eventually be recorded as cost of goods sold. Proceeds from the forced sale of excess supplies can also be deducted on an estimated basis.

48. Net income includes items of revenue that do not generate immediate cash. It also includes expenses that do not require the immediate use of cash. For a measure of cash available to meet fixed charges, the more relevant figure is "cash provided by operations" reported in the statement of cash flows. Net income can sometimes be used as a proxy of this more appropriate measure of cash availability.

49. Since Company B is under the control of Company A, the latter can siphon off funds from it to the detriment of B's creditors. Moreover, the customer supplier relationship with Company A means that Company A has considerable discretion in the allocation of revenues, costs, and expenses among the two entities in such a way as to determine which company will show what portion of the total available income. This again can work to the detriment of Company B's creditors. As a lender to Company B, one would want to write into the lending agreement conditions that would prevent parent Company A from exercising its controlling powers to the detriment of the lender.

50. Debt can never be expected to carry the risks and returns of ownership because of the fixed nature of its rewards. Also, it cannot serve as the permanent risk capital of a company because it must be repaid with interest. Moreover, debt is incurred on the foundation of an equity base. Indeed, equity financing shields or at least reduces the risks of debt financing. Equity financing also absorbs the losses to which a company is exposed. Consequently, the assertion is basically accurate.

51. The advantages of convertible debt are that the company is able to potentially enlarge its equity base (and/or at a potentially lower cost) than it might otherwise be able to with pure equity financing. Also, it might be able to sell equity shares at a price in excess of the current market price and to obtain, in the interim, a lower interest cost because of the conversion feature of the debt. The disadvantages are that a subsequent decline in the market price of the stock can postpone conversion substantially and indefinitely. This would leave the company with a debt burden that it was not prepared to shoulder over the long term. Consequently, what may have been conceived of as temporary financing can, in fact, become long term debt financing.

52. (a)  Long-term indentures span such an extended period of time that they are subject to many uncertainties and imponderables. Consequently, long term creditors often insist on the maintenance of certain ratios at specified levels and/or controls over specific managerial actions and policies (such as dividends and capital expenditures). However, no restrictive covenant or other contractual arrangement can prevent operating losses, which present the most serious risk to long-term creditors.

      (b) 1.  Maintenance of a minimum degree of short term liquidity.

• Prevention of the dissipation of equity capital by retirement, refunding, or the payment of excessive dividends.
• Preservation of equity capital for the safety of creditors.
• Insure the ability of creditors to protect their interests in a deteriorating situation.

53.     The major reason why debt securities are rated while equity securities are not rest in the fact that there is a far greater uniformity of approach and homogeneity of analytical measures used in the evaluation of credit worthiness than there is in the evaluation of equity securities. This increased agreement on what is being measured in credit risk analysis has resulted in widespread acceptance of and reliance on published credit ratings in many sectors of the analyst community.

54. In rating an industrial bond issue, rating agencies focus on the issuing company's asset protection, financial resources, earning power, management, and the specific provisions of the debt security. Asset protection is concerned with measuring the degree to which a company's debt is covered by its assets. Financial resources encompass, in particular, such liquid resources as cash and other working capital items. Future earning power is a factor of great importance in the rating of debt securities because the level and the quality of future earnings determine importantly a company's ability to meet its obligations. Earnings power is generally a more reliable source of security than is asset protection. Management abilities, philosophy, depth, and experience always loom importantly in any final rating judgment. Through interviews, field trips and other analyses the raters probe into management's goals, the planning process as well as strategies in such areas as research and development, promotion, new product planning and acquisitions. The specific provisions of the debt security are usually spelled out in the bond indenture.

• The analyst who can effectively execute financial statement analysis can also improve on the published bond ratings. Indeed, effective financial statement analysis is possibly even more valuable in the valuation of debt securities than in the case of equity securities. Bond ratings cover a wide range of characteristics and they present opportunities for those who can better identify key differences within a rating classification. Moreover, rating changes generally lag the market. This lag presents additional opportunities to an analyst who with superior skill and alertness can identify important changes before they become generally recognized.

 

• Companies hire bond-rating agencies to rate their debt because these ratings are an externally generated, independent signal of the company's creditworthiness and quality. Investors would rely less on ratings if they were produced in-house because of management's incentives to report high quality and of management self-interest. In short, they act as independent signals of debt quality.