Reading 42: Financial Statement Analysis: Applications-LOS c 2011, investment, potential, center, credit

1215

Session 10: Financial Reporting and Analysis: Applications and International Standards Convergence
Reading 42: Financial Statement Analysis: Applications

LOS c: Describe the role of financial statement analysis in assessing the credit quality of a potential debt investment.

 

 

Statement #1 – From a lender’s perspective, higher volatility of a borrower's profit margins is undesirable for floating-rate debt but not for fixed-rate debt.

Statement #2 – Product and geographic diversification should lower a borrower's credit risk.

With respect to these statements:

A) only one is correct.

B) both are incorrect.

C) both are correct.

---

 

Margin stability is desirable from the lender’s perspective for both floating-rate and fixed-rate debt. Higher volatility will increase credit risk. Product and geographic diversification should lower credit risk as the borrower is less sensitive to adverse events and conditions.

1215

When assessing credit risk, which of the following ratios would best measure a firm’s tolerance for additional debt and a firm’s operational efficiency?

Ratio #1 – Retained cash flow (CFO – dividends) divided by total debt.

Ratio #2 – Current assets divided by current liabilities.

Ratio #3 – Earnings before interest, taxes, depreciation, and amortization divided by revenues.

Tolerance for leverage

Operational efficiency

A) Ratio #1 Ratio #3

B) Ratio #2 Ratio #3

C) Ratio #3 Ratio #1

---

A firm’s tolerance for additional debt can be measured by its capacity to repay debt. Retained cash flow divided by total debt is one of several measures that can be used. Operational efficiency refers to the firm’s cost structure and can be measured by the “margin” ratios. EBITDA divided by sales is one version of an operating margin ratio. The current ratio is a measure of short-term liquidity.

1215

Selected financial information gathered from Alpha Company and Omega Corporation follows:

	Alpha	Omega
Revenue	$1,650,000	$1,452,000
Earnings before interest, taxes,   depreciation, and amortization	69,400	79,300
Quick assets	216,700	211,300
Average fixed assets	300,000	323,000
Current liabilities	361,000	404,400
Interest expense	44,000	58,100

Which of the following statements is most accurate?

A) Omega has less tolerance for leverage than Alpha.

B) Omega uses its fixed assets more efficiently than Alpha.

C) Alpha is more operationally efficient than Omega.

---

Using the EBITDA coverage (EBITDA / Interest expense) to measure leverage tolerance, Omega has less tolerance for leverage. Omega’s EBITDA coverage is 1.4 ($79,300 EBITDA / $58,100 interest expense) and Alpha’s EBITDA coverage is 1.6 ($69,400 EBITDA / $44,000 interest expense). Using EBITDA margin to measure operational efficiency, Alpha is less operationally efficient than Omega. Alpha’s EBITDA margin is 4.2% ($69,400 EBITDA / $1,650,000 revenue) and Omega’s EBITDA margin is 5.5% ($79,300 EBITDA / $1,452,000 revenue). Using fixed asset turnover to measure the efficiency of fixed assets, Omega uses its fixed assets less efficiently than Alpha. Alpha’s fixed asset turnover is 5.5 ($1,650,000 revenue / $300,000 average fixed assets) and Omega’s fixed asset turnover is 4.5 ($1,452,000 revenue / $323,000 average fixed assets).