New RMA Credit Risk Certification

Cash-to-cash cycle

keep it as short as possible! A measure of the number days between the time a company pays their supplier for inventory and the time that same company is paid for the same inventory by their customer

financial ratios are

liquidity leverage debt service

For Investors: Free Cash Flow model

net operating profit after tax (NOPAT) cash available minus investment in operating capital. Large publicly traded companies use this analysis. for distribution to investors after company has made investments for all assets and working capital necessary to sustain operations. Value of a company depends on future FCF's Net working capital + Net long term assets

own or lease an asset

own = depreciation capital lease agmt. = owner at end of lease operating lease only = rights and risk under lessor not company that effectively "rents it", therefore won't show up on balance sheet as asset

own or lease an asset

own = depreciation capital lease agmt. = owner at end of lease. operating lease only = rights and risk under lessor not company that effectively "rents it", therefore won't show up on balance sheet as asset

4. pretax profit margin- (income stmt)

profit before tax divided by net sales. are interest expense & non operating income and expenses well managed to protect operating profit? profit plus or minus interest income, expense and non operating income, expenses. determine if borrower will have to pay taxes. Profit before taxes is $2,377/$19,442 x 100 = 12.23% pretax profit margin (healthy would be less than 20% and service industry has the best)

software to calculate the key ratios

sageworks aka profitcents moody's spreadsheet

consolidating financial statements

show each separate company(s) and way accountant has eliminated intracompany transactions. is best but most expensive to prepare

separate or parent only financial statements

shows only parent company

depreciation methods

straight line, double depreciation and sum of the years

a company has a contribution margin of 50%. if the contribution margin increases, what best describes the break even revenue point?

the higher the company's contribution margin, the lower the company's breakeven revenue point. get some examples so i can remember.

sustainable growth is an automatic calculation by the software

this tells us how much the company can grow without any outside help. no loans or equity, etc.

Net Sales/Inventory - use in "what if" forecasting Carl Young CPA from Lorman

to budget or forecast you look at sales first. sales/inventory what if i increased? produce the greatest amt of sales from the least amount of ....whatever, inventory, assets, etc.

personal cash flow to calculate for global coverage

total income (salary + biz Income + rental income, etc)/debt service (personal p & i) take total income minus fed & state tax = cash flow to svc. personal debt. living allowance is 20 -30% of cash flow available to service debt is now required.

Debt to Equity Ratio carl young CPA from Lorman

total liabilities/total equity measures how the profit covers the debt burden Not encumbered by debt! debt should be much less than the equity i have! if i had to go out of business i want to be able to pay all of my debt off and have money left to walk away with.

carl young CPA Lorman class: conservative cash

want to cover liabilities with cash and marketable securities. 1.8 -2.1. make your cash liquid enough to pay the liabilities so that you are not encumbered by debt.

sources and uses

working capital financing 1 yr loc = assets (A/R or Inventory) capital expenditures 5 yr term = operating profits recapitalization 7 yr term= operating profits acquisition 5yr. term loan = operating cash flow

UCA Cash Flow-based Coverage Ratios:

-Debt Service Principal and Interest Coverage Ratio -Interest Coverage from Operating Cash Ratio

opinion letters

-Unqualified has most reliable data. -Qualified has one or more exceptions and limited. -Adverse opinion has material departures from GAAP. -Disclaimer opinion has significant doubt on reliability.

analyzing demands on cash flow

1. review c/flow stmt.: identify significant outflows for: working capital for sales growth (asset efficiency)...capital expenditures...dividends...debt service 2. review to separate cash outflows caused by sales growth from those caused by declining efficiencies or changes in trade credit 3. Is it a one time event or recurring? 4. can mgmt. control the demands 5. Compare to historical demands with historical sources. what are expected future demands?

accounts receivable efficiency (asset efficiency): Net Sales/A/R = turnover

2 measures to judge efficiency of A/R: A/R turnover & Days in A/R... Net Sales/A/R and that = A/R turnover. so divide 19,442,000 in Net Sales by 1,722,000 for A/R = 11.29 turnover - this means for every $1 in A/R there was $11.29 in sales OR A/R turned over 11.29 times during the yr. you can calculate days by: 365/11.29 turnover = 32.33 days OR Days Sales in A/R is calculated by taking A/R/Net Sales x 365. so 1,722,000/19,442,000 x 365 = 32.33 days in A/R. **big impact if days improve by 7.7 days yr over yr, and if last yr sales were 25,515,000 divide it by 365 days = 69,904.10 per day x 7.7 days equals savings of 538,261.64 this assumes that ALL sales are credit sales. if you have some cash sales, you may need to manually calculate by using only the credit sales. there may be some seasonal distortion as well. you can interpret by quarters in this case for averages. 1. Quantify effect on cash when days sales change. A/R days is a cash flow driver. the less days to receive the more cash flow. is collections improving? if improves 7 days even that is significant. 2. calculate if improved what the effect on cash flow liquidity is. 3. is there an allowance for doubtful accts or returns? recalculate if necessary. 4. compare the ratios with company peers. good mgmt can help a lot!

3. operating profit margin (income stmt)

= Operating profit divided by net sales. Do the mgmt. of cost of goods sold & operating expenses allow co. to be profitable? if operating profit is$2,607/$19,442 x 100 = 13.41% operating profit margin (very good) best to compare to industry too

quality of balance sheet long term assets

Fixed Assets: Quality of Property (Owned or rented) and Equipment can be loan collateral. gives idea of co. viability, can be source of secondary payment and may reveal future borrowing need. What is its value? Investments & Other long term assets: Not usually material source of repymt. Intangible Assets: future benefit to co. patents, copyrights and goodwill. Can they be a secondary source of repymt.? generally not.

balance sheet equation

Assets = Liabilities + Owner's Equity

cash flow statements and formats

Cash flow statements shows the sources and uses of cash. Investors find it the most transparent of the financial statements. WHAT IS THE CASH DOING? The cash flow from financing and investing activities' sections will be identical under both the indirect and direct method. Both produce the same result as well. Indirect method: Since it starts with net income on the income statement it must make adjustments to add back in depreciation and amort. (non cash items) & reflect "changes" in the working capital accounts yr over yr on the balance sheet (receivables, payables, inventories); the operating cash flow section shows how cash was generated during the period, by adding to or subtracting from net income to derive the operating cash flow. It is this translation process from accrual accounting to cash accounting that makes the operating cash flow statement so important. The direct method lists the cash receipts and payments from the income stmt. made during a period for a business' operations. The cash outflows are subtracted from the cash inflows to calculate the net cash flow from operating activities, (ignoring non cash items; depreciation and amortization) before the cash from investing and financing activities are included to get the net cash increase or decrease in the company. Cash flow from operating activities on direct form: Begins with Income stmt Sales 1,500,000.00 Wages and salaries (450,000.00) Cash paid to vendors (525,000.00) Interest Income 175,000.00 Income before income taxes $700,000.00 Interest paid (125,000.00) Income taxes paid (237,500.00) Net cash from operating activities $337,500.00 FASB requires a business using the direct method to disclose the reconciliation of net income to the net cash provided and used by operating activities that would have been reported if the indirect method had been used to prepare the statement. The reconciliation report is used to check the accuracy of the operating activities, and is similar to the indirect report. The reconciliation report starts off with listing the net income and adjusting it for non-cash transactions and changes in the balance sheet accounts. This added task makes the direct method unpopular among companies. UCA Direct - bankers prefer. not GAAP approved but calculates cash from operations then identifies interest and current portion of LTD as separate cash flow requirements. makes it easier to determine if interest & principal pymts can be serviced with cash from operations. operating cash flow - cash equivalent of income stmts profit from core biz activities. shows profit after cash flow cycle. (internally generated cash from profit).Retained earnings are found in operating cash flow because of profit or loss investing cash flow -cash flows from investing. buying or selling plant & equip. intangible assets, rental properties, and stock in affiliates and changes in marketable securities when securities are considered an investment instead of cash equivalent. (from long term assets) financing cash flow - shows changes in long or short term debt or equity. cash PROVIDED by outside lenders. must be evidenced by note or debt instrument (from long term liabilities) UCA method: 1) Gross cash margin: how much cash is left after COGS. Gross cash profit / net sales. 2) Cash after operations - take your gross cash profit minus operating expenses = total cash from operating. First, calculate cash operating expenses to determine if they are cash or non cash expenses & adjust thereto (add back any depreciation, then calculate + or - for accrued wages, insurance, pre-paids - from prior yr to this yr to increase or decrease cash) (what is the cash doing?) 3) Net cash after operations: adjust also for any other operating expenses labeled miscellaneous or "other" which could be minor asset, liabilities, income or expenses. *also adjust for taxes - what is tax provision this year, then what were deferred tax assets last yr compared to this year and what were deferred tax liabilities last year compared to this yr. & adjust for cash value. all of this gives you "net cash after operations". 4) Net cash income - $ left after dividends & interest have been pd. when its a positive number means company funded all working capital needs with operating cash flow. if its negative means non-operating sources of funds were needed 5) Cash after debt amortization = net cash income minus CPLTD. this tells you if co. had enough money to svc. current portion of long term debt. positive outcome means co can pay with internally generated funds. if negative, means there's a need for outside source to make up the difference. CASH COVERAGE RATIO which is: net cash after operations/financing costs + CPLTD. use the ratio to determine if a borrower can meet all its operating needs and still have sufficient funds to pay Principal & interest & dividends. a ratio less than 1.1 % means co must borrow to meet its obligations. 6) Financing surplus or Requirement - subtract capital expenditures from cash after debt amortization and this gives you a financing surplus or a requirement: if its a surplus its good and if its a requirement you can choose from 3 sources of external financing below. If its a surplus: usually co. will use surplus to pay off debt or simply leave in cash) If there is a requirement: 3 sources to fund a requirement: 1. equity infusion from stock, preferred stock, treasury or paid in capital. 2. increased borrowing with short term debt (LOC) 3. LTD financing - determine change in LTD (adjust all changes & add for total external financing number in financing debt. section) this will bring you to...cash after financing 7) Cash after financing: actual change in cash. this should match the cash account on the balance sheet for the company. Questions to ask with overall outcome: * has co pd interest from internally generated cash? * has co paid principal from internally generated cash? * how much cash did the co require? * how has co financed itself? Addl. questions for "quality" of cash flow are: * how does co generate cash? * how does co use cash? * how does co invest cash surplus OR finance the need? * what is my evaluation of co's financial flexibility? Are the appropriate sources of funds financing the appropriate uses of funds?

Profit-based Debt Service Coverage Measures What?

Profit-based measures directly relate the cash flow of potentially highest quality to the repayment of the loan.

5. net profit margin- (income stmt)

**after taxes is there a profit that is able to pay dividends or contribute to earnings as owners equity? net income divided by net sales. **extremely important for the business owners and they look at these margins daily!! net income is $1,527/$19,442 x 100 = 7.85% net profit margin (slim but fine) (need to compare to industry)

1. gross profit margin - (income stmt)

**is it profitable? measures profit after cogs. (income stmt). Gross profit/sales revenues = gross profit margin. Extremely important for the business owners and they s/look at daily! if gross profit is 8494 and sales are 19442 x 100 to express as a percentage of 43.69% is gross profit margin. (pretty good margin) (compare to industry)

Cash basis cash flow =

+ net cash after operations - mandatory capital expenditures - dividends - debt service so 800,000 net cash after operations/750,000 =1.07% most underwriters like 1.1% this is a very conservative model. advanced cash flow model.

extra cash flow statement knowledge for equipment gains and losses on an indirect c/flow stmt:

-proceeds on the sale of equipment has a positive effect on cash Equipment is a long-term asset. ***A decrease in any asset account (other than Cash) is assumed to be a source of Cash, provided Cash, or increased Cash. All of these are positive effects on Cash. [The entire "proceeds" from the sale of the equipment will be shown in the investing activities section of the statement of cash flows.] -a LOSS on the sale of equipment has a positive effect on cash: The loss (computed as proceeds minus the book value) appeared on the income statement and reduced the company's net income. However, the company's cash did not decrease. (Actually the company's cash increased by the amount received for the asset.) You need to add back the loss that reduced net income on the income statement so that the amount reflects the cash from operating activities. -the gain on sale of equipment formerly used in the biz has a negative effect on cash: (you lost the asset) therefore, we need to add back (show an increase) to the net income amount appearing in the operating activities section. The Gain on Sale of Equipment was an increase to the net income on the income statement. On the statement of cash flows we need to subtract the gain from the net income so that only the cash from operating activities appears in the operating activities section. This subtraction or decrease will also prevent the double counting of the gain, since the entire proceeds from the sale are reported in the investing activities section. -an increase in the long term asset of investing in another company has a negative effect on cash: *****An increase in any asset (other than Cash) is assumed to have a negative effect on Cash. It is assumed that Cash was used or decreased. -gain on sale of automobile decreases cash in operating section of cash flow stmt. The gain (computed as proceeds minus the book value) appeared on the income statement and increased the company's net income. However, the entire proceeds from the sale of a company's assets are shown in the investing section. In order to avoid double-counting the gain, the gain must be subtracted from the net income amount appearing in the operating activities section of the statement of cash flows.

z score - bankruptcy score

0-1.80 = danger of bk 1.81-3.00 = not looking good +3.00 = no bk characteristics you can google altman z score to calculate yourself

Two types of debt service coverage measures?

1) Profit-based-comes from cash flow 2)Cash flow-based (UCA) **Key difference between the 2 measures are that the interest coverage only measures interest from operating cash flow.

extra for cash flow statement knowledge for A/P & A/R on an indirect c/flow stmt:

A decrease in Accounts Payable will decrease cash on the cash flow stmt.: Accounts Payable is a current liability account. It is assumed that a company had to use or decrease Cash in order to decrease any liability. You could also think of negative amounts on the statement of cash flows as being unfavorable from a Cash point of view. Decreasing a liability is unfavorable or negative as far as Cash is concerned. TIP: The change in Cash will be the SAME direction as a change in the LIABILITY account balance. An increase in any liability will be a positive amount on the statement of cash flows (SCF). A decrease in any liability will be shown as a negative amount on the SCF. an increase in A/R will have a negative effect on cash. decrease cash: its an asset Accounts Receivable is a current asset. An increase in any asset (other than Cash) is assumed to have a negative effect on Cash. The change in Cash is the OPPOSITE sign of the change in the other ASSET'S balance.

leverage ratios are

A leverage ratio is any one of several financial measurements that look at how much capital comes in the form of debt (loans), or assesses the ability of a company to meet its financial obligations. The leverage ratio is important given that companies rely on a mixture of equity and debt to finance their operations, and knowing the amount of debt held by a company is useful in evaluating whether it can pay its debts off as they come due.

cash flow statement

A summary that shows total income and spending for a given time period

quality of balance sheet current assets

First, is there a high balance of cash and why. Find info in the notes to fin. stmts. Marketable securities: How liquid are they? A/R: total accts. Rec. notes to fin stmts. and Aging are important to analyze. what is A/R relationship to sales? Are there concentration in few customers? Is there a potential risk from customers who file BK to our borrower. Inventory: Assess marketability of inventory. Finished or unfinished goods? Risk of value loss? What is their share to industry market?FIFO or LIFO. Relationship to sales. Deferred Income tax Assets: are there any? Prepaids? Value is questionable.

seasonality strategies

Analyze interim fin stmts to review effects on cash. 3 patterns cause seasonal borrowing: 1. Seasonal sales; and effect on inventory. Inventory mgmt of Seasonality: Level Production-same through yr. Peak Period Production increase at peak periods. 2. Cash disbursements that may not be level are dividends, bonuses and tax pmts. 3. uneven cash receipts when special pymt terms are offered. (ex: farmer pays when crops sell) Cash budgets may help as it like a checkbook to anticipate s/term borrowing. determines when the cash is needed. Analyze seasonal and base level assets (A/R & inventory w/be higher during peak level and then shrink down to baseline again) to determine the current liabilities needed to support them during the fluctuation of sales and A/P, wages and short term loan needs.

Operating Performance: Profit margins - analyze using the income statement: gross profit margin; operating expense ratio; operating profit margin; pretax profit margin; net profit margin

Analyzing the income statement using the profit margins. Measure profitability of sales by using profit margins. Evaluate operating leverage on co's. profitability. divide each by net sales to get percentage ratio. operating expense ratio helps determine profit margin. analyze profit trends and perform industry comparisons using the NAICS code. (helpful to use the all & appropriate asset size) **Most analysts look at most importantly: gross profit margin! net profit margin! good to look at sales growth as well as percentage when looking at yr over yr. this will provide context for changes in: *expense mgmt *operating leverage *profitability which profitability measure areas is truly driving company's ability to generate profit. prudent to know that company will take some profit to pay their taxes. *can exclude extraordinary items for purpose of trend analysis.

business & industry cycles

Business Life cycle: -Early Expansion, when company is growing. need funds for sales growth and working capital. to finance cap expenditures; -Late expansion, hire workers invest and inventory grows, need money for growth; -Early contraction, pace growth slows, less optimistic, co's reduce debt and inventory to generate funds; -late contraction, recession. companies layoff, stop investment. need funds to offset fixed outlays. Industry life cycles and product life cycles: Introduction cycle; Growth stage; Mature stage; Declining stage. these will affect loan repayment ability. Company life cycles: -Intro cycle; need large capital ,product development, marketing and usually get money from owners. -Growth stage, need money for sales growth, inventory, A/R, mktg, product development, plant & equip; -Mature stage; likelihood for continued success is apparent. cost control., need $ for dividends, mktg and base level of inventory and A/R. -Declining stage: need to rejuvenate or profit protection, dividends, mktg and restructuring during downturn.

quality of retained earnings on income statement

Business practices enhance the quality of earnings. Maintaining and replacing or upgrading operating efficiency. Plan future products. Quickly charges off bad debts. enhance employee benefits. (net income or loss from income stmt. added to retained earnings & flows to balance sheet)

cash, modified cash & tax basis accounting methods

Cash Basis statements - Records revenues when cash is collected and expenses are the same. this will distort the profit unless super simple biz. cash basis will distort the truck purchase and depreciate all within the yr./ accrual basis adjusts income and expenses using matching principal and is better. Modified Cash basis statements is an in between way - typical to amortize PP & E and depreciates and recognize borrowed funds & taxes. this distorts assets and liabilities and profit. Mixes cash basis with accrual method. Tax Basis accounting - difficult to decipher w/out detailed explanations. Measure and record $ impact of transactions to income and expenses according to TAX RULES. (The basis of an asset is its cost to you)

extra cash flow statement knowledge for an indirect c/flow stmt:

Cash flow activities: when creating the cash flow statement: an increase in taxes payable will show as an increase in cash Income Taxes Payable is a current liability. An increase in any liability account (or in stockholders' equity) is assumed to increase Cash or at least be favorable from a Cash point of view. If Income Taxes Payable increased, the company did not pay the entire amount of Income Tax Expense shown on the income statement. Since the starting point in the operating activities section is net income, you add back the increase in Income Taxes Payable. To assist in understanding the increase or decrease, you could substitute 'favorable effect on Cash' for increases in liabilities. (Substitute 'negative effect on Cash' for decreases in liabilities.) If a payable increases, it means the company did NOT pay all of the bills and that has a favorable effect on Cash. Another way to remember the effect is that the effect on Cash will be the SAME direction as a change in the liability account balance. An increase in any liability will be a positive amount/effect on the statement of cash flows (SCF). A decrease in any liability will be shown as a negative amount/effect on the SCF.

Stockholders' Equity

Companies can raise money by selling shares of equity in the co. there are 2 kinds: 1. Preferred stock- shareholders get dividend payments ea. yr. and can accumulate and be carried over to the next yr. - have a priority over common stock shares w/respect to dividends, and in distribution of assets in event of bk. (little or no voting rights) 2. Common stock - owners of company. have voting rights.The value shown on a company's books for common stock is the dollar amount paid for the shares when they were originally sold to the investors when the stock was issued. This amount will most likely be quite different from the market value of the stock if it were to be traded on a public exchange like the New York Stock Exchange. If your company is publicly traded, you can check the value of its common stock through sites like Yahoo Finance. Also the co. may reinvest some of common shareholders money each yr.; this is the amt. by which net income exceeds the dividends pd. out to shareholders and appears on balance sheet as retained earnings. -Additional Paid in Capital -When a company sells shares of its own stock to the public, the amount that the sales price exceeds the par value is placed on the balance sheet as additional paid-in capital.

what is the debt to tangible net worth adjusted to consider subordinated debt as net worth (leverage ratio)

Debt to Tangible Net worth adjusted to consider subordinated debt as net worth; If an officer has subordinated debt, subtract total debt from liabilities and add it to net worth. this is known as effective tangible net worth. Remember to compare to industry averages. Financing assets with debt and equity can still allow for good leverage overall.

degree of operating leverage (DOL) (income stmt)

Degree of operating leverage (DOL): helps identify percentage of increase in profit if sales were to increase. DOL = Sales - variable costs/profit ***From income stmt: ***gross profit/operating income = DOL*** to compute profit: 19,442 - 13,730 - 3,133 = 2579 sales - variable- fixed = profit If companies sales are 19,442 less 13730 (variable costs) = 5712/profit of 2579 = 2.21 DOL shows how DOL magnifies If companies sales are increased by 10% , operating income should increase by 22.1% (10% x 2.21 = 22.1%). if decreased by 10% would be the same; 22.15% decrease fixed and variable are hard to distinguish without talking to the borrower. need their input.

quality of income statement expenses

Determine if authentic to generate legitimate revenues, and typical for company. do they truly benefit from the expense? a) cogs & trends = evaluate as % of sales ea. yr. also, beginning & end of inventory & have they changed from fifo to lifo? examine ea. major category and review comparability from yr to yr and to similar companies. b) operating, depreciation, changes in accounting methods, and is there likelihood of operating expenses to increase or decrease? c) "other income" and expense - most common source of other income are interest income, gains on sales from assets and non operating investments. most common expenses are the reverse. d) income taxes. creating efficiencies will improve.

quality of income statement revenues

Determine if revenues are authentic and sustainable. to determine authenticity, ex; Does co. have to perform more to collect the receivables or are they readily converted to cash? Sustainability? Will they continue and grow?

Fixed-charge Coverage Ratio

EBIT + Lease and Rental Expense / Int. Exp. + Lease and Rental Exp. +Prior-year CMLTD The ratio measures the ability to cover fixed charges (interest, lease/rent expense (which is found in notes to fin stmts) and CMLTD which is found on balance sheet as prior yr CPLTD or CMLTD) with profits after expenses Ratio of 1 means co has just enough to pay these fixed expenses. A ratio less than 1 means co is unable to meet expenses and another source of funds is needed.

Interest Coverage Ratio: EBIT/Interest

Earnings before Interest and Taxes (EBIT) / Interest Expense. So (Earnings (net income) + Interest + Taxes)/ Interest. (you ignore interest and tax expenses by adding them back in) The ratio measures the ability of a company to cover interest on its debt. Higher the ratio is greater margin of protection. Ratio less than 1 means co cannot meet interest obligations from operating income. shows how well you are covering your current interest payments. 2 x or better is just making it. do better!

asset turnover (asset efficiency); ratio of net sales to total assets. Net sales/net fixed assets

Efficiency with which a company uses its assets to generate revenues: turnover ratios tell us if more assets are needed. net sales/total fixed assets = total asset turnover. the higher the ratio the better. (net sales found on income statement and total assets on the balance sheet) This tells you what the company can do with what it has! so 1.35 means for every $1. spent , co. generated $1.35 - Return on assets over 5% are generally good. (Net sales of 500,000 / Assets of 100,000 = 5) but these vary GREATLY by industry. if the ratio is higher than its competitors it means the co. uses its fixed assets to generate sales BETTER than its competitors. this can help determine borrowing causes & repayment sources.

what is contribution margin (income stmt) operating leverage

Enables you to calculate break even point. how many sales dollars are required to cover fixed expenses; ***Sales - COGS = contribution margin***(common sized) sales less variable expenses divided by sales x 100 = contribution margin % this measures portion that exceeds variable expenses and "contributes" to pymt. of fixed costs. express as a percentage. If sales are 19,442 and variable expenses are 13,730, take remaining 5,712 divided by sales of 19,442 = 29.38% This is its contribution margin. so 1/3 of co.'s sales are available to cover fixed expenses.

Benefits of Profit-based Debt Service Coverage?

Facilitate communication with the borrower. Remind us of the importance of real, sustainable income as a component of cash flow

audited financial statements

Financial statements that have been examined by an independent auditor to determine whether they fairly represent the financial condition of the business

consolidated financial statements

Financial statements that show all (combined) activities under the parent company's control, including those of any subsidiaries.

a/p efficiency (current liability): Days in A/P = A/P /COGS or purchases x 365

For mfg's. divide accounts payable by purchases For resellers divide accounts payable by COGS. Rather than turnover measure we like to use days payable instead as its more reliable. COGS is mainly used & for RMA is always used. A/P/COGS x 365 = days in A/P "Company's cash cycle is the total of: +A/R days + days in inventory minus A/P days For a mfg: If have $700,000 in AP/ divide by purchases of 8,000,000 x 365 = 31.93 days in A/P. Reducing days payable by 2 days means you lose an additional 1,400,000 in cash. Suppliers extending more generous pymt terms will help in cash flow. There may be some seasonal distortion as well. you can interpret by quarters in this case for averages. 1. determine which way to calculate - COGS or purchases 2. quantify effect on cash when changes 3. identify trends and reasons for them 4. compare with industry composites to see how effective mgmt. is in control

Free Cash Flow

Free cash available to support sales and operations. formula: cash from operations minus capital expenditures. $83,000- $20,000 = $63,000 commonly accepted metric for corporate success as opposed to earnings per share.

Cash flow quality

Highest quality cash flows are from repeatable and sustainable profits. a)those that Improve margin of protection. b) are sustainable and c) result of co's economic earning power. Second best quality would be improving asset efficiencies in; cash flow cycle (decreasing days in A/R & Inventory & A/P extending days) & equity proceeds. Lowest quality is from additional debt or a sale of an asset. It's important to also identify the Demands on cash flow and be careful not to underestimate them. Borrowing causes are a good place to start: We need cash flow for the following: Demand on sales growth? Demands from asset inefficiency? Need for Fixed asset capital expenditures? Need to pay dividends? if it neglects dividends it may reduce its ability to attract new capital. Debt service?

common sizing

Identify trends by using common sizing. Balance sheets asset, liability and net worth is calculated as a percent of total assets. Income statement is calculated by percent of total sales, making it easy to spot trends from yr to yr. ex; if cogs grew profitability may decline.

liquidity ratios are

Liquidity ratios are a class of financial metrics used to determine a debtor's ability to pay off current debt obligations without raising external capital. Liquidity ratios measure a company's ability to pay debt obligations and its margin of safety through the calculation of metrics including the: *current ratio, *quick ratio *and operating cash flow ratio or net working capital ratio (** to be ultra conservative you can exclude from assets and liabilities: prepaid expenses, due from officers, shareholders & employees & then calculate.)

Limitations of Profit-based Debt Service Coverage

Imply that all net income has equal cash potential. Do not account for major demands on cash flow, like taxes, dividends, fixed asset expenditures or working capital required because of sales growth. Imply that loan repayment will have a first claim on cash flow.

what is the debt service coverage ratio:net income/current liabilities

In corporate finance, the debt-service coverage ratio (DSCR) is a measurement of the cash flow available to pay current debt obligations. The ratio states net operating income as a multiple of debt obligations due within one year, including interest, principal, and lease payments. net operating income + interest, tax, depreciation and amortization/total current liabilities 1.20 is our standard

Profit-based Coverage Ratios:

Interest Coverage Ratio Fixed-charge Coverage Ratio Debt Service Coverage Ratio EBITDA to Principal and Interest My bank will use one of these ratios or a modified version of them.

leverage trends and liability structure from the balance sheet. 4 measures of leverage: debt to net worth; debt to tangible net worth; net fixed assets to tangible net worth & debt to tangible net worth adjusted to consider subordinated debt as net worth.

Liability structure has an impact on company's ability to repay loans = current liabilities, long term liabilities and net worth. Long term assets s/be funded w/ long term debt (liabilities) IF can't be funded by net worth. Current assets s/be supported by current liabilities. Banks provide high portion of financing for mfg. and wholesalers, and less for retail and service companies, which are financed more by owners, suppliers and employees. Leverage trends are the relative proportions of borrowed money and owners money to support assets. important to lenders because gives us margin of protection by owners investment in co. assets. 4 measures of leverage: debt to net worth, debt to tangible net worth, net fixed assets to tangible net worth, & debt to tangible net worth adjusted to consider subordinated debt as net worth. the less ratio is the better for leverage ratios

borrowing causes and repayment sources

Long Term Borrowing Causes: 1) Declining asset efficiency (A/R, Inventory), Estimate A/R inefficiency (days sales in A/R) and Inventory inefficiency. (days COGS in inventory) 2) Sales growth means A/R & Inventory growth Estimate increases in A/R and Inventory 3.) Fixed asset expenditures, - Estimate need for new asset(s) and unexpected costs associated with 4) Change in trade credit - Estimate changes 5)Decreases in net worth - are more risky. (to pay dividends would be temporary) trends (causes) must change. Long Term Repayment Sources: (1) Improving Asset Efficiency 2) Leveling-off of Growth, or Sales Decline 3) Sale of Non-current Assets 4) Increase in Trade Credit 5) Increase in Net Worth 1. why does the company need the money? Will the cause reverse and provide its own source of repymt? (like A/R efficiency, or inventory efficiency improves) or will another source of repymt. be needed? (from profit? owner investment? increase in other liabilities like another bank? sale of non-current assets? 2. how much does it need & will the need continue? 3. how long will it need the money? permanent or temporary? -Temporary needs can be met with seasonal lines of credit or revolving lines or credit; short-term loans, such as 90-day extensions of credit. - Long-term needs can be met with permanent working capital loans (1- to 3-year revolving credit); installment, term or mortgage loans to finance an acquisition; or term loans to provide long-term finance for reductions in a company's net worth.

**what is debt to net worth ratio (leverage ratio)

Main Leverage Ratio: Debt to net worth: total current liabilities plus long term debt/divided by total equity (net worth). the larger the ratio the greater the risk. want under 1. need to consider leases not reported on balance sheet and commitments or contingencies as well. 3.0 is max max & under 1 is great. **from balance sheet take total current liabilities + ltd to = total liabilities/ total equity. then look at debt to income (DTI) for the individual (guarantor) 44% or less max: total monthly debt/total monthly income

comparability

Must compare to similar companies and RMA studies. Asset valuations/ROI/Pension/expense recognition. Accounting changes for same company must be compared to prior years.

comparability

Must compare to similar companies and RMA studies. Asset valuations/ROI/Pension/expense recognition. Accounting changes for same company must be compared to prior years. Industry sector influence differences. asset distributions: Mfg.= % of assets in cash is similar to wholesalers and retailers. higher need for cash. A/R assets for mfg. sell mostly on credit terms and may offer liberal terms to boost sales and loyalty. % of inventory; substantial amt. of inventory. Mfg. will have high percentages of Fixed assets./ wholesalers & retailers- need for cash is lower than mfg. because of shorter operating cycle. A/R assets are same as Mfg. sales mostly on credit and can offer liberal terms. % of inventory for wholesalers may be lower as they usually lease their premises. retailers on the other hand carry much inventory. generate revenue from inventory and A/R more than from fixed assets, so have lower % of fixed assets. service industries like law firms. have high cash percentages means they rec. retainers, don't need fixed assets so have lot of cash assets. A/R assets are lower because they bill up front depending on type of service biz. % of inventory are supplies as inventories. modest inventory is logical. range for fixed asset needs is different for each svc. sector. Only companies with assets less than 250,000,000. are used in RMA's composites. All sales sizes are used and the larger ones are lumped into the 25 million & over. Ratios are shown in quartiles; upper, median and lower quartile use naics code.

Debt Service Principal and Interest Coverage Ratio

Net Cash after Operations / Cash Paid for Int. + prior yr. CMLTD + Current portion Capital Leases This ratio measures the ability to cover interest, principal loan payments, and current capital leases with net cash after operations.

EBITDA to Principal and Interest

Net Profit + Tax + interest + Deprec.+Amort./ Prior-year CMLTD + Interest Expense This ratio measures the ability to cover principal and interest with the current year's net profit before interest, tax, and for non-cash charges (Add back in interest, taxes, depreciation, amortization and depletion). This coverage ratio excludes income taxes and interest expense before tallying resources available to service debt and it adds interest expense to the principal payment. A ratio greater than 1 is good. A ratio less than 1 means co cannot meet financial obligations out of profit adjusted for interest and non cash charges.

**Debt Service Coverage Ratio - EBITDA (Cash flow coverage)

Net Profit after + Interest +Tax + Deprec. + Amort. + Depletion / Prior-year CMLTD (Term Debt due this yr) This ratio measures how many times CMLTD is covered by the current year's net profit after tax adjusted for non-cash expenses (add back interest, tax, depreciation, amortization and depletion). A ratio greater than 1 means co generates enough profit to pay loan pymts. A ratio less than 1 means does not. 1.20 is standard. Personal Cash Flow: Salary + Business Income + Rent Income, etc. = Total Income Less Federal & State Taxes = Cash Flow available for debt service. (most lenders want the 1.20) Global cash flow = net income for both/debt = global cash flow (combining the two. 1.20x is the minimum standard)

what is the net fixed assets to tangible net worth ratio (leverage ratio)

Net fixed assets to Tangible Net worth ratio: Net fixed assets divided by tangible net worth. Ratio greater than 1 suggests company is relying on liabilities to fund a portion of fixed assets. (Ideally net fixed assets are totally supported by owners equity). if ratio of 1.34 shows they have 1/3 reliance on debt to fund the fixed assets.

quality of balance sheet net worth accounts

Net worth is difference between company's assets and liabilities. is there a common stock account? Additional pd in capital? Review retained earnings from the notes. Do they grow with profits each yr? Understanding if the income must be distributed to the flow through company.'s owners to pay taxes. ...and Do they pay dividends to shareholders and how much is reinvested into the business. Owners Equity or net worth

operating leverage - income statement: contribution margin; breakeven point; degree of operating leverage (DOL)

Operating leverage and its effect on profitability: is the degree to which a firm or project can increase operating income by increasing revenue. degree of expenses that are fixed (rent, depreciation, office salaries, property taxes, etc.) vs. variable. if fixed costs are high - company has high leverage; with high leverage profits go up if sales increase because fixed costs remain the same if fixed costs are low - company has low leverage because if sales decrease it must still pay its fixed costs & will suffer as profits decrease because its fixed costs remain the same. DOL = sales - variable costs/profit if you can keep variable costs at minimum you can increase profit. figure out following 3 things: 1) Contribution Margin 2) Breakeven Point 3) Degree of operating leverage (DOL): helps identify percentage of increase in profit if sales were to increase.

cash flow statement

Operating, investment and financing activities. Investing cash flow's involve purchase and sale of fixed assets like buildings and equipment, & purchase or sale of investing instruments, like stocks or bonds, lending $ or collection of loans. (cash activities related to non current assets) Financing cash flow's show how cash has been raised externally. Bank borrowing, long-term borrowing, receiving cash for sale of stock or spending cash to repurchase stock. Repaying investors too. (cash activities related to long term liabilities and owners equity)

working capital turnover: ratio of annual net sales/working capital

Ratio of annual net sales (found on income stmt.) to working capital (found on balance sheet as current assets minus current liabilities). Net sales/Working capital. = working capital turnover Expresses a company's balance sheet and cash needs in relation to net sales. used to assess liquidity cushion. if you have net sales of 20,000 and working capital of 5,000 so 20,000/5,000 = 4 (sales to working capital ratio). this means for every $1 in working capital you have $ 4 in sales. this provides a liquidity cushion as it has more current assets than liabilities. a lower ratio is a higher cushion whereas a higher ratio has a lower cushion. too low is not using assets effectively and too high is too many assets not destined to produce a profit soon. complete a balance sheet quality analysis to determine what is an appropriate working capital turnover ratio for the company. when co ratio gets 12-15 the liquidity is getting very thin. (not good) 2 steps to analyze: 1.determine what working capital should be & compare to industry avg. 2. identify significant changes (by looking at asset efficiency's) and determine the cause

income statement-

Revenue - expenses = net income (profit or loss or net income or loss) measures operating performance

cash cycles - benefits and limitations

Sometimes called asset conversion cycle. cash flows to inventory, then receivables, then back to cash. the need for the inventory portion is affected by the help of what's available in trade payables. when a company cannot get through a cash cycle, it will need to borrow. it will be long term borrowing if cash cycle lengthens for sales growth or declining efficiency. it will be short term if it is a temporary lengthening of the cash cycle or increase need for daily cash. (could be seasonality) To Measure the cash cycle: + days sales in receivables + days COGS in inventory (or purchases for mfg's) minus days in A/P = average days in cash cycle. cash cycle can reveal sources for loan repayment. limitations are that it excludes "other payments than COGS" that the co has. (dividends, tax, pension, selling expenses) & can mask seasonality. Different Industries have different needs for cash: Restaurants, hotels, supermarkets, have shorter cash cycles and little need for working capital as they generate revenues immediately on sale. these co's can operate with negative working capital. (more liabilities than assets). Mfg''s, wholesalers, retailers have longer cash cycle and can't operate successfully with negative working capital. compare yr. over yr. and company will have less need for cash if it's improving efficiencies and shortening their cash cycle. OR you will see a need for cash.

spreading financial statements - balance sheet adjustments

The Purpose is to record reclassifications, simplify the format by providing added detail. must read notes to fin stmts. common adjustments of current assets to non current are pre-paids; separate current & long term. reclassify and don't count stale receivables over 90 days if no allowance for bad debt is reported. any questions on inventory? gross fixed assets? some leasehold improvements can be reclassified to fixed assets if the leasehold improvement is done by a related entity and will hold a guaranty to the banks debt. separate accruals such as accrued wages or interest payable to help interpret as well. Now for reclassifying liabilities: classify notes to related parties to put in non current receivables, or in investing section of cash flow stmt. overdrafts should be put in current liability and not in negative cash. A/P from related entities should be put in current liability. notes to related s/be current liability.

Statement of Retained Earnings

The statement that summarizes the income earned and dividends paid over the life of a business. its the Link from income stmt to balance sheet. take balance of retained earnings from last yr + income or loss in current year (inc.stmt) - dividends paid (distr. of net income to owners) = retained earnings for this year (transferred to bal.sheet in owners equity section)

inventory valuation

The value of the inventory at either its cost or its market value. Because inventory value can change with time, some recognition is taken of the age distribution of inventory. Therefore, the cost value of inventory is usually computed on a FIFO basis, LIFO basis, or a standard cost basis to establish the cost of goods sold. LIFO can understate probable profit in rising price environment

inventory valuation

The value of the inventory at either its cost or its market value. Because inventory value can change with time, some recognition is taken of the age distribution of inventory. Therefore, the cost value of inventory is usually computed on a FIFO basis, LIFO basis, or a standard cost basis to establish the cost of goods sold. LIFO can understate probable profit in rising price environment LIFO understates profit in rising price environment

productivity ratios using balance sheet and income statement: ROA, return on assets: ROE, return on equity or net worth

These ratio are important for publicly traded companies, but not for small to medium sized businesses. Productivity and profitability ratios: is companies ability to generate profit from assets. ROA - net income/total assets return on assets (divide profit before or after tax by total assets). variations can take taxes & extraordinary items out of equation for more accurate ratio. (don't want assets to grow faster than sales) Returns 5% + are considered good ROE - net income/net worth return on equity or net worth productivity is calculated by dividing net income (from the profit before or after taxes on the income statement) by net worth. (on the balance sheet) (is it attractive as an investment?) 15-20% are considered good variation 1: profit before tax. "profit before tax divided by net worth" to take the tax implications out of equation. variation 2: return on average equity is; add equity at beginning of period to equity at end of period and divide by 2. variation 3; divide profit before taxes by tangible net worth. best to use with RMA's composites. outcome is to see a decline or improvement in productivity. good mgmt. will use equity vs debt supporting co assets with their capital vs taking on new debt.

what is the total liabilities to tangible net worth (leverage ratio)

Total liabilities to tangible net worth: tangible net worth minus intangibles = tangible net worth. then take the total liabilities divided by net worth for "total tangible net worth" An intangible asset is an asset that is not physical in nature. Goodwill, brand recognition and intellectual property, such as patents, trademarks and copyrights, are all intangible assets.

UCA Cash Flow Based Debt Service Coverage Measures What?

UCA cash flow-based measures isolate cash interest and principal payments, allowing the measurement of operating cash flow before considering interest and principal. Benefits of UCA Cash Flow-based Debt Service Coverage? Show accurate measures of cash available to service debt Limitations of UCA Cash Flow Based Debt Service Coverage? Borrowers unfamiliarity with the UCA cash flow statement make it difficult to discuss the measures with a borrower and include them as loan covenants in a credit agreement

opinion letters

Unqualified has most reliable data. Qualified has one or more exceptions and limited. Adverse opinion material departures from GAAP. Disclaimer opinion has significant doubt on reliability.

lifo will show less profit because...

With rising costs of merchandise, the most recent purchases will have higher costs. Taking the last (most recent) costs out of inventory first will mean the recent higher costs will be matched against current sales. (This leaves the older lower costs in the Inventory account.) Matching the latest/recent/higher costs against current sales results in less profit, less taxable income, and less income tax expense than FIFO or an average cost.

assessing the sustainability and quality of ongoing cash flow for a co.

a co. manufactures aftermarket batteries to large parts distribution resellers. some 90% of co's biz is conducted through long-term, fixed price contracts with 5 of the largest aftermarket parts resellers. remaining contract maturities range from 6 mos. to 4 yrs. we have provided a working capital LOC for the past several yrs. What w/be our greatest concern to assess sustainability of ongoing cash flow? a. fluctuations in exchange rates and interest rates b. changes in industry technology/supply distribution c. bankruptcy filing of a major customer or loss of customer contract d. excess inventory/finished goods a. is incorrect. b. could have an impact but unlikely as batteries not subject to rapid obsolescence, and industry is mature. d. is possible but unlikely due to fixed contracts. c is correct because its an operating activity and the one that the co. has the least control over. loss of a major customer could significantly impact ongoing cash flow.

2. operating expense ratio - (income stmt)

are costs of mktg & distributing a product well managed to protect gross profit. (Total op expenses divided by net sales). if op expenses at $5,915/$19,442 x 100 = 30.42% op expense ratio (compare to industry)

extra cash flow - assets and liabilities & their effect on cash flow

assets have the opposite effect on cash flow: ex: A/R increases = decrease of cash flow liabilities have the same effect as the change in cash flow: -A/P increases = positive (increase) on cash flow

what is the breakeven point (income stmt) operating leverage

breakeven point: tells how many sales dollars are needed to cover fixed expenses (break even) fixed expenses/contribution margin %. = breakeven point so. fixed expenses of ***general & admin expenses/contribution margin (common size %) = breakeven point so if fixed expenses are 3,133, divide by contribution margin of 29.38% = 10,663.72 sales dollars are needed to breakeven. (which is good cushion) With each dollar in sales revenue earned beyond the break-even point, the company makes a profit.

analysis of A/R for new request working capital

in reviewing a clients A/R schedule as part of new request for working capital finance; my review reveals there is a 60% concentration in 2 accounts. both are large publicly traded with AA debt ratings. i need to evaluate the ongoing collectibility of the 2 and their value as collateral. Which of the following is most important to my analysis? a. clients standard payment terms b. stock price of publicly traded clients c. other selling terms and conditions d. economic, environmental and regulatory issues Answer: C other selling terms and conditions could have major impact on receivable value based on discounts, allowances, restocking agreements and the like. a,b and d would have little if any impact.

extra cash flow knowledge

gains or losses on sale of equipment show in operating section of cash flows. "proceeds" go to investing section

inventory efficiency (asset efficiency): Inventory turnover ratio: COGS/Inventory=turnover ratio

determine efficiency for inventory turnover is a prime cash flow driver. how many times has the co sold inventory during a given time period. Inventory Turnover ratio = COGS / inventory so if COGS is 10,948 divide it by inventory of 2,742 = 3.9927 turnover so for every $1 of inventory there was $3.9927 in COGS OR inventory turned over 3.99 times during the year. To calculate Days COGS in inventory, take 365/3.99 (inventory turnover) = 91.42 days OR multiply inventory/COGS x 365. so if inventory is 2,742/10,948 x 365 = 91.42 days in inventory **can impact big if days improve from last year to this yr. by 15.24 days less time in inventory... COGS was 15,423,000 last yr. / 365 days = 42,250 per day in COGS. Take 42,250 improvement per day x 15.24 days saved =$643,890 1. quantify effect on cash needed to invest in inventory when changes 2. identify trends and reasons for them 3.compare with industry composites to see how effective mgmt. is in inventory control

extra fifo vs. lifo..A company in the computer industry is experiencing continuously lower costs. Which cost flow assumption will result in less income tax expense for this company?

fifo: Because costs are declining over time, the first or oldest costs are the higher costs. Matching these higher/older costs against current revenues will result in lower profits, lower taxable income, and lower income tax expense.

spreading financial statements - income statement adjustments

get details from the notes. Vital to break out non cash expenses such as depreciation from COGS and amortization to permit calculation of cash flow measures. Separate interest expense to facilitate measurement of dsc. Examine every non operating income and non operating expense to ensure they should be in operating profit section. Gain or sale of an asset may be adjusted to "other income or expense" as it is non recurring. Royalties would be the same. Adjust revenues from discontinued operations; best treated as extraordinary gains or losses. (not operating income anymore) . Other comprehensive income like gains or losses from marketable securities or foreign exchange rate items should not be in income stmt but in balance sheet equity section, and note gains or losses held to maturity are probably on balance sheet already.

quality of balance sheet liabilities

help us to evaluate the timing of payments due: Current - the greater the current liabilities, the greater the need for cash and other highly liquid assets. Non current - deferred liabilities can be deferred revenue (which will be income next yr.) or deferred taxes liabilities. (which could be an accelerated depreciation method being used and tax dollars being deferred. this effectively reduces tax liability and helps show more income on the income stmt) Existing liabilities can present opportunities for refinancing. Loans not pd by our proposed financing will compete for cash avail for dsc. look for commitments and contingencies (found in the notes to fin stmts) and when they may be due. it will affect cash needed. do reserves need to be set aside?

measuring and analyzing liquidity using balance sheet, current ratio; quick ratio; net working capital ratio

how liquid are the current assets to meet current liabilities: current ratio,= total current assets/total current liabilities. greater than 1 is good. 2.0 is great. quick ratio; quick assets: total current assets minus inventory(least liquid asset)/ by current liabilities. this tells us if we can quickly pay current liabilities if necessary. greater than 1 is acceptable. NET working capital ratio = current assets minus current liabilities; and what is left is a source of funds. working capital is a long term source of funds. Good ratio is 1.2 - 2.00 (not a true ratio, it's a mathematical equation) for individual liquidity; give credit for: cash 100% mutual funds 75% individual stock unlisted 0% IRA's 50% personal liquidity is strength as guarantor

working capital = current assets - current liabilities

i may have working capital that looks good, but if i dont have the cash liquid some would say i am Ill advised to go buy something if i dont have enough cash. Have the cash to do it, not debt. (if at all possible)