Bachelor of Business Administration
Semester VI
Credit Analysis
FIN 3235 – Financial Reporting and Analysis
Kasun Perera
Department of Finance
Faculty of Management and Finance
University of Colombo
Learning Outcomes
• At the end of this lesson you will be able to;
– Interpret liquidity and working capital
– Identify the repercussions of lack of liquidity
– Analyse the composition of liquidity and working capital
ratios
– Apply current ratio
2
Liquidity and Working Capital
• Liquidity:
Ability to convert assets into cash or to obtain cash to
meet short term obligation
• Working Capital:
The excess of current assets over current liabilities
3
Liquidity and Working Capital (Contd.)
Repercussions of lack of liquidity
• Lack of liquidity prevents a company from taking advantage of
favorable discounts or profitable opportunities
• More extreme liquidity problems reflect a company’s inability
to cover current obligations
• This can lead to forced sale of investments and other assets at
reduced prices and, in its most severe form, to insolvency and
bankruptcy 4
Liquidity and Working Capital (Contd.)
• Lack of liquidity can foretell a loss of owner control or loss of
capital investment
• Particularly, when the owners possess unlimited liability, lack
of liquidity endangers their personal assets
5
Liquidity and Working Capital (Contd.)
• To creditors of a company, a lack of liquidity can yield
delays in collecting interest and principal payments or the
loss of amounts due them
• Implications include a company’s inability to execute
contracts and damage to important customer and supplier
relationships
6
Liquidity and Working Capital (Contd.)
• Working Capital:
✓Widely used measure of short-term liquidity
✓A measure of liquid assets that provide a safety cushion to
creditors
✓Important in measuring the liquid reserve available to meet
contingencies and the uncertainties surrounding a
company’s balance of cash inflows and outflows
7
Liquidity and Working Capital (Contd.)
• Contingent liabilities associated with loan guarantees and it
needs to assess the likelihood of this contingency materializing
• Contracts for construction or acquisition of long-term assets
often call for substantial progress payments and these are
reported in the footnotes as “commitments” and not as
liabilities in the balance sheet
8
Liquidity and Working Capital (Contd.)
• But,
9
Liquidity and Working Capital (Contd.)
• Relevance of the current ratio
✓Current liability coverage
The higher the amount (Multiple) of current assets to current liabilities, the greater assurance we
have that current liabilities will be paid
✓Buffer against losses
The larger the buffer, the lower the risk. The current ratio shows the margin of safety available to cover
shrinkage in noncash current asset value when ultimately disposing of or liquidation then
✓Reserve of liquid funds
Margin of safety against uncertainties and random shocks to a company's cash flows. Uncertanities and
shocks, such as strikes and extraordinary losses, can temporarily and unexpectedly impair cash flows.
10
Current Ratio
• Numerator Considerations
✓Failure to reflect open lines of credit (cash substitutes)
✓Failure to adjust securities valuation since the balance sheet date
✓Reflect revolving nature of accounts receivables
✓Does not recognize sales level or profit margin in inventory
✓Unnecessary prepaid expenses
• Denominator Considerations
✓Payables vary with sales
✓Current liabilities do not include prospective cash outlays - certain
commitments under construction contracts, loans, leases, and
pensions 11
Current Ratio (contd.)
• Liquidity depends to a large extent on prospective cash flows and to a
lesser extent on the level of cash and cash equivalents
• No direct relation between balances of working capital accounts and
likely patterns of future cash flows
• Managerial policies regarding receivables and inventories are directed
primarily at efficient and profitable asset utilization and secondarily at
liquidity
• Two elements integral to the use of current ratio;
✓ Quality of both current assets and current liabilities
✓ Turnover rate of both current assets and current liabilities 12
Current Ratio – Application
• Comparative analysis
✓ Trend analysis - must be interpreted with caution
✓ Company expansion often accompanying operating success can create
larger working capital requirements
✓Prosperity squeeze in liquidity decreases the current ratio and is the result
of company expansion unaccompanied by an increase in working capital
13
Current Ratio – Application (contd.)
• Ratio management (window dressing)
✓ Towards end of the period management will occasionally
o Press the collection of receivables
o Reduce inventory below normal levels
o Delay normal purchases
o Proceeds from these activities are then used to pay off
current liabilities
14
What-If Analysis
• Useful technique to trace through the effects of changes in
conditions or policies on the resources of a company
• Example
15
• Consolidated Technologies is considering a change in credit policy where
ending accounts receivable reflect 90 days of sales. What impact does this
change have on the company’s cash balance? Will this change affect the
company’s need to borrow? 16