A5470-Chapter 10

Q21: What are the repercussions to a company of overinvestment and underinvestment in inventories?

(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.

Q52: What is the reason for provisions regarding maintenance of minimum shareholder's equity?

2. Prevention of the dissipation of equity capital by retirement, refunding, or the payment of excessive dividends.

Q52: What is the reason for provisions regarding Restrictions on dividend payments?

3. Preservation of equity capital for the safety of creditors.

Q52: What is the reason for provisions regarding power of creditors to elect a majority of the board of directors of the debtor company in the event of default under terms of the loan agreement?

4. Insure the ability of creditors to protect their interests in a deteriorating situation.

Q42: What is the difference between common-size analysis and capital structure ratio analysis?

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.

Q52: What is the reason for restrictive covenants?

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.

Q15: What is the appropriate use of the current ratio as a measure of liquidity?

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.

Q4: Certain installment receivables are not collectible within one year. Why are these receivables sometimes included in current assets

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.

Q5: Are all inventories included in current assets? Why or why not?

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.

Q33: Why should a company not increase its debt to 90 percent of total capitalization?

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

Q27: Describe the importance of sales in assessing a company's current financial condition and the liquidity of its current assets.

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.

Q2: Working capital equals current assets-current liabilities. Identify and describe factors impairing the usefulness of working capital as an analysis measure

-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. -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.(may expand current assets and liabilities) 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.

Q47: A What what conditions do you include a noncancelable contract in computing fixed charges?

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.

Q11: Since cash generally does not yield a return, why does a company hold cash?

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.

Q16: What are cash based ratios of liquidity? What do they measure?

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.

Q24: A successful company can have a poor current ratio. Identify possible reasons for this.

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.

Q50: Debt is a supplement to, not a substitute for equity financing

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.

Q52: What is the reason for provisions regarding maintenance of aluminum working capital?

Maintenance of a minimum degree of short term liquidity.

Q36: What is off balance sheet financing?

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.

Q18: What does accounts receivable turnover measure?

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.

Q14: What are the limitations of the current ratio as a measure of liquidity?

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.

Q10: What is the current ratio? What does it measure? What are reasons for using the current ratio for analysis?

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

Q45: What does the earning to fixed charges ratio measure?

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.

Q29: What is the importance of what-if analysis on the effects of changes in conditions or policies for a company's cash resources?

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.

Q40: A. Why might you need to adjust book value of assets for analysis? B. Give three examples for the need for possible adjs to book value

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. (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.

Q30: Identify several key elements in the evaluation of solvency.

• 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.