ISL459U-FINANCIAL STATEMENT ANALYSIS
Chapter 6: Short Term Debt Paying Ability Analysis
The Concept of Working Capital
The total of current assets is called “Gross Working Capital” in financial statement analysis. Gross working capital enables the business to make cash purchases, cash payments for expenses, production and sales activities and to pay short term debts
The Distributions and Conversion of Current Assets with Regard of Gross Working Capital
Current assets are also called “operational assets” because they are frequently used and consumed in day-to-day activities.
Current assets frequently covert from one category to another category within the current assets during the annual operations. This is also called business or operating cycle and under ordinary business cycle, cash is used to purchase merchandise inventories, raw materials and/or supplies, to pay for labor and other expenditures.
As a result of these, merchandise inventories or finished goods will be sold on cash or on credit, and cash will be collected from customers later and cash will be generated from operations. This cycle will be repeated as long as the business is able to continue its operations. The more this cycle is well-planned and swift, the more the gross working capital will be used efficiently and effectively.
The difference between current assets and current liabilities is denoted as “net working capital”. The excess of current assets over current liabilities is called “Net Working Capital”; if the total amount of current assets is less than the amount of current liabilities, the difference is called “Net Working Capital Deficit”.
Net working capital allows a business to pay its short-term liabilities and to continue its day-to-day operations. Therefore, the total current assets should be higher than total current liabilities.
Factors Determining Need for Net Working Capital
There are a lot of factors affecting net working capital needs. These are briefly explained below:
• The Nature and Character of Activities of Business • Production and Delivery Time of Finished Goods • Unit Cost of Inventories • Sales Volume • Terms and Conditions of Purchases and Sales • Inventory Turnover • Receivables Turnover • Economic Conditions • Possibility of Impairment on Current Assets • Whether the Sales are Seasonal/Cyclic or Evenly Distributed throughout the Year • Technology Utilization
Determining the Ability to Pay Short Term Debts by Using Comparative Financial Statements (Horizontal Analysis)
The purpose of horizontal analysis is to examine changes in items on financial statements both as an amount and as a percentage by using a base year. When determining the ability to pay short term debts by using comparative financial statement analysis (horizontal analysis), changes in the items of current assets and current liabilities are examined. In this approach, changes in both the total amounts of current assets and liabilities and also each item in current assets and liabilities are analyzed.
Determining the Ability to Pay Short Term Debts by Using Trend Analysis
Trend analysis is made for understanding direction of items on financial statements. It is made by using 3 or more years’ financial statements. In determining the ability to pay short term debts by using trend analysis, trends of the items in current assets and current liabilities are examined. Based on this examination, projections can be made. Trend analysis is made by using a base year and comparing the amounts in the following years, usually by comparing percentage change with the previous years.
If current assets and current liabilities are increasing and there is correlation in the increase of both current assets and current liabilities, it is assumed that the business has ability to pay short term debts. If current assets and current liabilities are decreasing and there is correlation in the decrease of both current assets and current liabilities, it can also be assumed that the business has ability to pay short term debts. On the other hand, if the change in current assets and current liabilities is not parallel to each other, it must be monitored carefully. For example, if there is a tendency of sharp decrease in current assets but a sharp increase in current liabilities, the ability to pay its short-term liabilities will be significantly weakened.
Determining The Ability to Pay Short Term Debts by Using Vertical Analysis
In vertical analysis, current assets and current liabilities and also each item is divided by the total amount of assets and the composition of these percentages are examined. By using these percentages, the amounts of these items in the future financial statements are projected. In vertical analysis for analyzing the ability to pay short term liabilities, the percentages of current assets and current liabilities are compared to each other.
For examining the distribution of the items in currents assets, the percentages of each item are computed. Then, these are compared to the percentages of those businesses in the same or similar sectors. Besides, it is important that the percentages of liquid assets (cash etc.), marketable securities and receivables are relatively high compared to other current assets such as inventories. If the percentages of these items are high, it is assumed that the business has
ability to pay its short-term liabilities. On the other hand, the percentages of inventories should not be so high since they cannot be easily turned into cash. For inventories it is also important to keep sufficient level of inventories.
In examining the current liabilities, it is important to check the percentages of trade payables and short-term bank loans. Since short term bank loans have generally a higher interest rate than the interest rate of trade payables, they should be lesser.
Determining The Ability to Pay Short Term Debts by Using Ratio Analysis
There are a lot of ratios that can be used directly or indirectly for analyzing the ability to pay short term liabilities, however the most important of them are liquidity ratios. Some of the activity ratios are also useful in analyzing the ability to pay short term debts.
Analysis of Ability to Pay Short Term Debts by Using Liquidity Ratios
Liquidity ratios are the ratios that measure the ability of a business to meet its short-term debt obligations.
Current assets are cash and those assets that are expected to be collected, sold, used, consumed within one year, starting from the balance sheet date. Similarly, the liabilities also fall into two categories; current (short term) liabilities and long-term liabilities. Current liabilities are those obligations that are expected to paid or settled within one year, starting from the balance sheet date.
This composition of the balance sheet is not coincidental. Current assets and current liabilities (also called operational assets and liabilities) are used to conduct operations, they constantly change during the activities; for example, cash turns into inventories, inventories turn into trade receivables, trade receivables turn into cash. When cash is not sufficient, short term liabilities are needed to continue the operations, for example credit purchase of inventories is made.
On the other hand, non-current assets are also used in producing goods and services, however they are not turned into another asset such as cash during operations. Acquiring non-current assets usually requires a substantial payment, long term liabilities such as bank loan is preferred in such a credit purchase. Equity financing is also an alternative for long term financing, businesses may create funds by issuing new capital paid by the current or new shareholders. However, compared to financing by long term liabilities, equity financing is rarely used.
It will not be wise for a business to get a 10 years’ bank loan to purchase inventory on credit, it should prefer to buy on short term debt. On the other hand, a non-current asset is usually not purchased on a short-term debt, since it is expected to be used more than one year. Therefore, current liabilities are related to current assets, non-current liabilities are related to non-current assets.
Liquidity is related to convertibility of an asset to cash. Liquidity ratios helps in analyzing to which degree the current assets are able to meet short term liabilities. It demonstrates the relations between the items of current assets and current liabilities.
Liquidity ratios
The most common liquidity ratios are as follows:
• Current Ratio: The current ratio indicates a company's ability to meet short-term debt obligations. The current ratio measures whether or not a firm has enough resources to pay its debts over the next 12 months. The higher the ratio, the more liquid the company is. Commonly acceptable current ratio is 2; it's a comfortable financial position for most enterprises. Low values for the current ratio (less than 1) may indicate that a firm may have difficulty meeting current obligations. The current ratio is computed as follows: Current Ratio = (Current Assets) / (Current Liabilities) • Quick ratio (also called liquidity ratio or acid- test ratio): The most basic definition of quick ratio is that, it compares the current debts to the liquid assets, marketable securities and receivables. It is computed as; Quick ratio = (Liquid Assets + Marketable securities + Receivables) / (Current liabilities) Inventory is not included in the calculation of the quick ratio as it can be quite difficult for a business to convert all its inventory into cash within a short period of time. The exclusion of inventory from the formula makes the quick ratio a better indicator of a company’s ability to pay- off its current obligations than the current ratio which does include inventory in its formula. • Cash Ratio: Cash ratio (also called cash asset ratio) is the ratio of a company's cash and cash equivalent assets to its total liabilities. Cash ratio is a refinement of quick ratio and indicates the extent to which readily available funds can pay off current liabilities. Potential creditors use this ratio as a measure of a company's liquidity and how easily it can service debt and cover short- term liabilities. It only looks at the company's most liquid short-term assets – cash and cash equivalents – which can be most easily used to pay off current obligations. Cash ratio is computed as follows; Cash Ratio = (Liquid Assets + Marketable Securities) / (Current Liabilities) • Inventory Dependency Ratio: This ratio is used in measuring dependency of the business to its inventories for paying its short term liabilities, if the quick ratio is less than 1. It indicates the percentage of inventories that must be sold in order to pay short term debts, after the sum of
liquid assets and marketable securities are used for this payment. In order to compute the inventory dependency ratio, the total of liquid assets and marketable securities is subtracted from the current liabilities, and then divided by inventories.
Determining the Ability to Pay Short Term Debts by Using Cash Conversion Cycle
The liquidity of a business is measured by liquidity ratios; they are very useful in examining the ability to pay short term debts. However, these ratios are static, and sometimes may not be sufficient to understand this ability. Therefore, a more dynamic measure is required, which is cash conversion cycle. It is widely accepted that cash conversion cycle (CCC) is very important in working capital management.
The length of time between a business's purchase of inventory and the receipt of cash from accounts receivable is called “operating cycle”. It is the time required for a business to turn purchases into cash receipts from customers. It represents the number of days a firm's cash remains tied up within the operations of the business.
The cash conversion cycle (CCC) is computed as follows; “days inventory outstanding” (DIO) plus “days sales outstanding” (DSO) minus “days payable outstanding” (DPO). The CCC is equal to operating cycle minus days payable outstanding. The CCC is equal to the time is takes to sell inventory and collect receivables less the time it takes to pay the company's payables;
Cash Conversion Cycle (CCC) = DIO + DSO – DPO
If the cash conversion cycle is higher, the business will be short of cash for a longer period, therefore will seek for other financing options such as short-term bank loans. A higher net working capital will be needed. If the CCC is low, it is regarded as a positive indicator of efficiency of operations. CCC can even be negative; for instance, if the company has a strong market position and can dictate purchasing terms to suppliers (i.e. can postpone its payments). For example, in discount markets, it is usually a minus figure, because they buy with long repayment periods and sells mostly on cash.
In manufacturing companies, usually the CCC is relatively higher, because they usually sell their goods in large quantities with longer collection periods.
A short cycle allows a business to quickly acquire cash that can be used for additional purchases or debt repayment. The lower the cash conversion cycle, the healthier a company generally is. Businesses attempt to shorten the cash conversion cycle by speeding up payments from customers and slowing down payments to suppliers.