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Unformatted text preview: Chapter 10 - Credit Analysis 10-1 Chapter 10 Credit Analysis REVIEW 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. Chapter 10 - Credit Analysis 10-2 OUTLINE 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...
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