ENTERPRISE RESTRUCTURING: BASICS

1
ENTERPRISE RESTRUCTURING BASICS

• Introduction to Balance Sheets and Income
  Statements
• The balance sheet summarizes the financial
  position of an organization at a given moment, it
  is a snapshot of the firm. The balance sheet
  reflects the status of the organizations assets,
  (the economic resources owned by the
  organization), liabilities (debts owned to
  creditors), and equity (the owners investment in
  the organization).

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ENTERPRISE RESTRUCTURING BASICS

• As its name implies the balance sheet should
  indicate that these elements are in balance.
• Assets Liabilities Equity
• This fundamental relationship must always
  exist, because the assets represent the things
  owned by the organization and the liabilities and
  equity indicate how much was supplied by both
  creditors and owners.

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ENTERPRISE RESTRUCTURING BASICS

• In contrast to the balance sheet, the income
  statement shows the organization's financial
  progress over a given period of time. The income
  statement is also based on equation
• Revenues - Expenses Profit (or Loss)

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ENTERPRISE RESTRUCTURING BASICS

• Revenues are the resources, primarily cash,
  coming into the organization as a result of goods
  sold or services rendered. Expenses are the
  resources used by the organization to provide
  goods or services. If revenues are greater than
  expenses, the business has realized a profit. If
  expenses exceed revenue the business has realized
  a loss from operations. As you read the
  following detailed descriptions of balance sheets
  and income statements, keep in mind that there is
  a direct and important relationship between the
  two. The profit (or loss) realized by a business
  over a period of time affects the amount of
  equity. Equity in a business comes from two
  sources Direct investment by the owners and
  profits from business operations. Therefore, the
  bridge between the income statement and the
  balance sheet is in the relationship between
  equity and profit or loss.

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ENTERPRISE RESTRUCTURING BASICS

• Income Statements
• Exhibit 1 shows a sample income statement (see
  next page) for a period covering January 1 to
  December 31, 1989. The company in question
  earned revenues from two sources
• Net sales All sources earned by the company
  from the sale of its products and services.
• Other income Generally resources from sources
  as interest on bank accounts, cash dividends from
  investments in other companies, and interest on
  bonds.

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ENTERPRISE RESTRUCTURING BASICS

• The following expenses are subtracted from
  revenues
• Cost of goods sold all the expenses incurred in
  making the products sold during the period,
  including the cost of materials, labor, and
  factory overhead (rent, utilities and
  maintenance).

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EXHIBIT 1SAMPLE INCOME STATEMENT
Company X For year ending December 31, 1989 (In
LE) Revenues Net Sales 3,787,248 Other
Income 42,579 Total Revenues 3,829,827 Expenses
Cost of Goods Sold 2,796,459 Administrative
Selling Expenses 637,509 Interest
Expenses 47,516 Total Expenses 3,503,545 Earnings
Before Income Taxes 326,282 Income
Taxes 152,039 Net Earnings 174,243
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ENTERPRISE RESTRUCTURING BASICS

• Administrative and selling expenses The costs
  of running and promoting the business, including
  items like the presidents salary, the salaries
  of all management personnel, advertising costs
  and sales commissions.
• Interest expenses The interest that the company
  paid during the year on money that it borrowed.

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ENTERPRISE RESTRUCTURING BASICS

• Other Expenses This would include any other
  unusual expenses incurred by the company to run
  the business not otherwise accounted for above
  (e.g. research and development expenses, and
  organizational costs).

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ENTERPRISE RESTRUCTURING BASICS

• Expenses are subtracted from revenues to yield
  a figure that indicates the companys earnings,
  but this figure still does not reflect the
  companys profit. During 1989 the company paid
  over 46 percent of its earnings to the tax
  department in the form of taxes. Thus, its net
  earnings, or the amount of profit the company
  earned in 1989, is LE 174, 243.

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ENTERPRISE RESTRUCTURING BASICS

• Balance sheets
• Exhibit 2 is the balance sheet for Company X
  as of December 31, 1989. The first component is
  assets, current and fixed. Current assets, are
  those the business expects to turn into cash
  during the next year. The cash generated from
  current assets is used to pay expenses and repay
  liabilities. Current assets include

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ENTERPRISE RESTRUCTURING BASICS

• Cash.
• Marketable securities Temporary investments
  (generally 90 days) of excess or idle cash
  listed at cost, or market value since they are
  converted into cash within one year.
• Accounts Receivable Money owned to the company
  by debtors, generally for the purchase of goods
  and services.
• Inventories The value of products that have
  been completed and are in storage waiting to be
  sold (finished goods), products that have been
  partially completed (work in process), and raw
  materials.
• Prepaid Expenses The value of items that the
  company has paid for in advance, such as
  insurance premiums.

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ENTERPRISE RESTRUCTURING BASICS

• Fixed assets are things of value that will
  provide benefits to the company for one or more
  years. Fixed assets are reported in three
  categories land, buildings, machinery and
  equipment. Fixed assets are reported on the
  balance sheet at the cost to purchase or acquire
  the asset minus the depreciation accumulated on
  the assets since the time of purchase.
  Depreciation is the estimated decline in the
  useful value of an asset due to gradual wear and
  tear. Since this decline in value cannot be
  estimated with certainly, accountants use various
  standards methods to approximate it.

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SAMPLE BALANCE SHEET
Company X December 31, 1989 Assets Liabilities
Current Assets Current Liabilities Cash 59,770
Notes Payable 48,563 Marketable
securities 87,466 Trade accounts
payable 207,887 Accounts receivable 559,144 Payrol
ls other accurables 411,362 Inventory 618,120 In
come taxes 124,684 Prepaid Expenses 49,986 Total
Current Liabilities 792,496 Total Current
Assets 1,374,486 Long-Term Liabilities 431,350 Fix
ed Assets Total Liabilties 1,223,846 Land 25,807
Buildings 716,076 Shareholders
Equity 1,103,190 Machinery Equipment 1,010,770
Less allowances for depreciation 800,103 Total
Fixed Assets 952,550 Total Assets 2,327,036
Total Liabilties Equity 2,327,036
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ENTERPRISE RESTRUCTURING BASICS

• The second major section in a balance sheet is
  devoted to liabilities. Current liabilities are
  the debts that a company must pay off within the
  coming year
• Notes payable Money owned to banks or other
  lending institutions generally short-term loans
  (up to one year) used to finance short-term needs.

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ENTERPRISE RESTRUCTURING BASICS

• Accounts payable Money owed to vendors for the
  purchase of goods and services.
• Payrolls and other accurables Money owed to
  people for institutions that have performed
  services, including salaries owed to employees,
  salaries owed to employees on vacation, attorney
  fees, insurance premiums, and pension funds.
• Income taxes Money owed to the Tax Department
  may sometimes be deferred and paid later but must
  always be paid.

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ENTERPRISE RESTRUCTURING BASICS

• Long-term liabilities are obligations, usually
  loans, that are due to be paid not in the current
  year but in some future period. The amount
  specified in the balance sheet is equal to the
  total amount borrowed.

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ENTERPRISE RESTRUCTURING BASICS

• The final major section, the equity section
  summarizes the owners investment in the
  business. Individuals and institutions become
  owners of a company by purchasing shares of the
  companys stock. Equity increases as more people
  purchase stock and the company retains increased
  profit.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• Each type of analysis of financial data has a
  purpose or use that determines the different
  relationships emphasized. Therefore, it is
  useful to classify ratios into four fundamental
  types
• Liquidity ratios, measure the firms ability to
  meet its maturing short-term obligations.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• Leverage ratios, measure the extent to which the
  firm has been financed by debt.
• Activity ratios, measure how effectively the firm
  is using its resources.
• Profitability ratios, measure managements overall
  effectiveness as shown by the returns generated
  on sales and investment.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• Liquidity Ratios
• Generally, the first concern of the financial
  analyst is liquidity. they measures the
  short-run solvency of a company its ability to
  meet current debts.
• Current Ratio
• The current ratio indicates whether there are
  enough current assets to meet current
  liabilities.
• Current ratio Current assets
• Current liabilities

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• Current assets normally include Cash,
  marketable securities, accounts receivable, and
  inventories.
• Current liabilities consist of accounts
  payable, short-term notes, payable, current
  maturities of long-term debt, accrued income
  taxes, and other accrued expenses (principally
  wages).

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• When is the company solvent? When the current
  ratio is 1.0 or greater that is, the company
  should have more current assets than current
  liabilities.
• Method for Calculating the Current Ratio
• Add cash, marketable securities, accounts
  receivable, and inventories to get current assets.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• Add notes payable, trade accounts payable,
  payrolls and other accurables and income taxes to
  get current liabilities.
• Divide the derived current assets figure by the
  calculated current liabilities figure.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• You have now derived the current ratio. Now,
  compare the value derived to 1.0. If the
  current ratio is 1.0 or greater, the company
  should have more current assets than current
  liabilities and is financially viable or solvent.
  If the current ratio is less than 1.0, the
  company will have more current liabilities than
  current assets and is financially unviable or
  insolvent.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• For significance this ratio should be compared to
  previous years (e.g. the current ratio for five
  previous years should be derived). This is
  necessary in order to derive a trend. If the
  current ratio is rising n an upward fashion, the
  company is becoming more financially viable. If
  the current ratio is falling and assuming a
  downward trend, the company is becoming less
  financially viable.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• One helpful activity is to also compare the
  current ratio of the company in question to the
  current ratio of similar competing companies. If
  the company in question has a higher current
  ratio on a regular basis over a number of years
  than this company is more financially viable. On
  the other hand, if the company in question has a
  lower current ratio on a regular basis over a
  number of years than this company is less
  financially viable.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• b - Quick Ratio, or Acid Test
• The quick ratio is calculated by deducting
  inventory from current assets, and dividing the
  remainder by current liabilities. Inventories
  are deducted since they are typically the least
  liquid of a firms current assets.
• Quick ratio Current assets - Inventory
• Current Liabilities

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• When is the company solvent? When the Quick
  ratio is 1.0 or greater.
• Which liquidity ratio is more accurate, the
  current ratio or the quick ratio? The quick
  ratio, since it excludes inventory, the least
  liquid asset, and the asset on which losses are
  most likely to occur in the event of liquidation.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• Method for Calculating the Quick Ratio
• Add cash, marketable securities and accounts
  receivable (items 16, 17, 18 on the sample
  balance sheet on page 6) to get quick assets
  (quick assets by definition is current assets -
  inventory).

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• Add notes payable, trade accounts payable,
  payrolls and other accurables and income taxes
  (items 31, 32, 33 34 on the sample balance
  sheet on page 6) to get current liabilities.
• Divide the derived quick assets figure by the
  calculated current liabilities figure.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• You have now derived the quick ratio. Now,
  compare the value derived to 1.0. If the quick
  ratio is 1.0 or greater, the company should have
  more quick assets than current liabilities and is
  financially viable or solvent. If the quick
  ratio is less than 1.0, the company will have
  more current liabilities than quick assets and is
  financially unviable or insolvent.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• For significance this ratio should be compared to
  previous years (e.g. the quick ratio for five
  previous years should be derived). This is
  necessary in order to derive a trend. If the
  quick ratios is rising in an upward fashion, the
  company is becoming more financially viable. If
  the quick ratio is falling and assuming a
  downward trend, the company is becoming less
  financially viable.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• One helpful activity is to also compare the quick
  ratio of the company in question to the quick
  ratio of similar competing companies. If the
  company in question has a higher quick ratio on a
  regular basis over a number of years then this
  company is more financially viable.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• Leverage Ratios
• Leverage ratios measure the funds supplied by
  owners as compared with the financing provided by
  the firms creditors.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• Implications of leverage ratios
• Equity, or owner-supplied funds, provide a margin
  of safety for creditors. Thus, the less equity,
  the more the risks of the enterprise to the
  creditors.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• Debt funding enables the owners to maintain
  control of the firm with a limited investment.
• If the firm earns more on the borrowed funds than
  it pays in interest, the return to the owners is
  magnified.
• If the firm earns more on the borrowed funds than
  it pays in interest, the return to the owners is
  magnified.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• Low leverage ratios Indicate less risk of loss
  when the economy is in a downturn, but lower
  expected returns when the economy booms.
• High leverage ratios indicate the risk of large
  losses, but also have a chance of gaining high
  profits.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• Therefore, decisions about the use of leverage
  must balance higher expected returns against
  increased risk.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• Approaches to examining leverage ratios
• Debt ratio
• The debt ratio is the ratio of total debt to
  total assets and measures the percentage of total
  funds provided by creditors.
• The debt ratio is Total debts
• Total assets

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• Method for Calculating the Debt Ratio
• Add notes payable to long-term liabilities to get
  total debts.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• Add cash, marketable securities, accounts
  receivable, inventories, prepaid expenses, land,
  buildings, machinery and equipment and subtract
  depreciation to derive the total assets figure.
• Divide the total debts figure by the calculated
  total assets figure.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• For significance this ratio should be compared to
  previous year (e.g. the debt ratio for five
  previous years should be derived). This is
  necessary in order to derive a trend. If the
  debt ratio is rising in an upward fashion, the
  company is developing a leverage problem. If the
  debt ratio is falling and assuming a downward
  trend, the company is investing more of its own
  resources to generate assets and is becoming less
  dependent on debts.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• One helpful activity is to also compare the debt
  ratio of the company in question to the debt
  ratio of similar competing companies. If the
  company in question has a higher debt ratio on a
  regular basis over a number of years, then this
  company is over leveraged in comparison to its
  competitors. On the other hand, if the company
  in question has a lower debt ratio on a regular
  basis over a number of years, then this is less
  dependent on debt as a source of financing in
  comparison to its competitors.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• B - Debt-to-Equity- Ratio
• This ratio is a variation of the debt ratio that
  is commonly used. It compares the amount of
  money borrowed from creditors to the amount of
  shareholders investment made within a firm.
• Debt-to-Equity ratio Total Debts
• Shareholders investment (equity)

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• Method for Calculating the Debt-to-Equity Ratio
• Add notes payable to long-term liabilities to get
  total debts.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• Look up the shareholders investment or equity
  line item in the blance sheet.
• Divide the total debts figure by the calculated
  shareholders investment figure.

48
ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• For significance this ratio should be compared to
  previous years (e.g. the debt to equity ratio for
  five previous years should be derived). This is
  necessary in order to derive a trend. If the
  debt to equity ratio is rising in an upward
  fashion, the company is developing a leverage
  problem. If the debt ito equity ratio is falling
  and assuming a doward trend, the company is
  investing more of its owners resources to
  generate assets and is becoming less dependent on
  creditors.

49
ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• One other helpful activity is to also compare the
  debt to equity ratio of the company in question
  to the debt equity ratio of similar competing
  companies. If the company in question has a
  higher debt to equity ratio on a regular basis
  over a number of years, then this company is over
  leveraged in comparison to its competitors. On
  the other hand, if the company in question has
  lower debt to equity ratio on a regular basis
  over a number of years, then this company is less
  dependent on debt as a source of financing in
  comparison to its competitors.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• Profitability ratios
• Profitability ratios indicate how successful a
  company really is and how effective management is
  in operating the business.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• A - Return on assets
• This ratio shows how much money the company
  earned on each dollar it invested in assets. It
  is a measure of overall company earning power or
  profitability.
• Return on Assets (ROA) Net Earnings
• Total Assets

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• Method for Calculating the Return on Assets
  Ratio
• Derive the net earnings, or net profit figure
  from the income statement. Net earnings is
  simply total revenues minus total expenses.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• Add cash, marketable securities, accounts
  receivable, inventories, prepaid expenses, land,
  buildings, machinery and equipment and subtract
  depreciation to derive the total assets figure.
• Divide the net earnings figure by the derived
  total assets figure to get return on assets.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• For significance this ratio should be compared to
  previous years (e.g. the return on assets ratio
  for five previous years should be derived). This
  is necessary in order to derive a trend. If the
  return on assets ratio is rising in an upward
  fashion, the company is making a larger return on
  funds invested in assets. If the return on
  assets ratio is falling and assuming a downward
  trend, the company is making a lower return on
  funds invested in assets.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• One other helpful activity is to also compare the
  return on assets ratio of the company in question
  to the return on assets of similar competing
  companies. If the company in question has a
  higher ROA on a regular basis over a number of
  years, then this company is financially better
  off in comparison to its competitors. On the
  other hand, if the company in question has a
  lower ROA on a regular basis over a number of
  years, then this company is financially worse off
  in comparison to its competitors.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• B - Profit Margin
• The profit margin is a ratio that shows the
  relationship between net earnings and net sales
  and indicates how much profit the company is
  earning on each dollar in sales.
• Profit Margin Net Earnings
• Net Sales

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• Method for calculating the profit margin ratio
• Derive the net earnings, or net profit figure
  from the income statement. Net earnings is
  simply total revenues minus total expenses.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• Derive the net sales line item from the income
  statement.
• Divided the net earnings figure by the derived
  net sales figure to get the profit margin.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• For significance this ratio should be compared to
  previous years (e.g. the profit margin ratio for
  five previous years should be derived). This is
  necessary in order to derive a trend. If the
  profit margin ratio is rising in an upward
  fashion, the company is making a larger return on
  sales. If the profit margin is falling and
  assuming a downward trend, the company is making
  a lower return on sales.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• One other helpful activity is to also compare the
  profit margin of the company in question to the
  profit margin of similar competing companies. If
  the company in question has a higher profit
  margin on a regular basis over a number of years,
  then this company is making a larger return on
  sales in comparison to its competitors. On the
  other hand, if the company in question has a
  lower profit margin on a regular basis over a
  number of years, then this company is making a
  lower return on sales in comparison to its
  competitors.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• C - Return on equity (or return on net worth)
• This ratio indicates the amount of net earnings
  resulting from investments in equity.
  Shareholders are particularly interested in this
  ratio, because it shows them how much they are
  earning on their investments.
• Return on equity Net Earnings
• Shareholders investment (Equity)

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• Method for calculating the return on equity
  ratio
• Derive the net earnings, or net profit figure
  from the income statement. Net earnings is
  simply total revenues minus total expenses.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• Lookup the shareholders investment or equity
  line item in the balance sheet.
• Divide the net earnings figure by the derived
  shareholders investment figure to get return on
  equity.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• For significance this ratio should be compared to
  previous years (e.g. the return on equity ratio
  for five previous years should be derived). This
  is necessary in order to derive a trend. If the
  return on equity ratio is rising in an upward
  fashion, the company is making a larger return on
  funds invested by shareholders. If the return on
  equity is falling and assuming a downward trend,
  the company is making a lower return on funds
  invested by shareholders.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• One other helpful activity is to also compare the
  return on equity of the company in question to
  the return on equity of similar competing
  companies. If the company in question has a
  higher return on equity on a regular basis over a
  number of years, then this company is making a
  larger return on shareholders investment in
  comparison to its competitors. On the other
  hand, if the company in question has a lower
  return on equity on a regular basis over a number
  of years, then this company is making a lower
  return on shareholders investment in comparison
  to its competitors.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• Activity ratios
• Activity ratios measures how effectively the firm
  employs its resources. These ratios involve
  comparisons between the level of sales and the
  investment in various asset accounts, like
  inventories and accounts receivable.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• A - Inventory turnover
• Inventory turnover tells us how many times during
  the year the entire stock of inventory was sold.
• Inventory turnover is calculated as follows
• Inventory turnover Sales
• Inventory

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• Method for calculating the inventory turnover
  ratio
• Derive the net sales line item from the income
  statement.
• Derive the inventory valuation figure from the
  balance sheet.
• Divide the sales figure by the derived inventory
  figure to get the inventory turnover.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• Problems in arising in calculating and analyzing
  this ratio
• Sales are at market prices. If inventories are
  carried at cost, as they generally are, it is
  more appropriate to use cost of goods sold in
  place of sales in the numerator of the formula.
• Sales occur over the entire year, whereas the
  inventory figure is for one point in time. This
  makes it better to use an average inventory,
  computed by adding beginning and ending
  inventories and dividing by 2.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• B - Average collection period
• The average collection period indicates how
  quickly the company collects its accounts
  receivable.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• It is computed in the following way
• Annual sales (derived from the income statement)
  are divided by 365 to get average daily sales.
• Accounts receivable (derived from the balance
  sheet) are divided over daily sales to find the
  number of days sales is tied up in receivables.

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• The average collection period represents the
  average length of time the firm must wait to
  receive cash after making a sale and is
  mathematically defined as follows
• Average collection period Accounts
  receivables
• Sales/365 days

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ANALYSIS OF BALANCE SHEETS AND INCOME STATEMENTS

• Evaluation of this ratio is based upon the terms
  on which the firm sells its goods. For example,
  if the collection period over the past few years
  for a given company is lengthy while its credit
  policy did not change, this would be evidence
  that steps should be taken to expedite the
  collection of accounts receivable.

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SUMMARY OF FINANCIAL RATIOS
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SUMMARY OF FINANCIAL RATIOS (CONTD)
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FINANCIAL RATIOS
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FINANCIAL RATIOS
II. Ratios indicating asset relations and
capital set-up or relating to analysis of
long-term solvency
A. Equities related to profits and sales
1. Sales to owners equity
Net Sales Owners Equity
Numberof times net worth is turned over in
sales Indicative of the utilization of owners
capital may reflect over-capitalization in
relation to volume of business done.
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FINANCIAL RATIOS
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FINANCIAL RATIOS
100
FINANCIAL RATIOS
101
FINANCIAL RATIOS
102
FINANCIAL RATIOS
103
HOW TO ANALYZE FINANCIAL POSITIONPOTENTIAL FOR
BUSINESS FAILURE

• A comprehensive quantitative indicator used to
  predict failure is Altmans Z-score, which
  equals
• Working capital Retained earnings
• X 1.2
  X 1.4
• Total assets Total assets
• Operating income MV of common preferred
• X 3.3
  X 0.6
• Total assets Total liabilities
• Sales
• X 0.999
• Total assets
• N.B. Operating income Net sales - cost of
  goods sold

104
THE SCORES AND THE PROBABILITY OF SHORT-TERM
ILLIQUIDITY FOLLOW.

• Score Probability of illiquidity or failure
  
• 1.80 or less Very high
• 1.81- 2.99 Not sure
• 3.0 or greater Unlikely

105
EXAMPLE

• A company presents the following information
• Working capital 280,000
• Total assets 875,000
• Total liabilities 320,000
• Retained earnings 215,000
• Sales 950,000
• Operating income 130,000
• Common stock
• Book Value 220,000
• Market Value 310,000
• Preferred stock
• Book value 115,000
• Market value 170,000

106

• Z-score equals
• 280,000 215,000 130,000
• X 1.2 X 1.4
  X 3.3
• 875,000 875,000 875,000
• 480,000 950,000
• X 0.6 X 0.999
  
• 320,000 875,000
• 0.384 0.344 0.490 0.9 1.0846
  3.2026
• The probability of failure is not likely

107
CONSOLIDATED BALANCE SHEETS
December 31, 1993 1992 Assets Cash 9,150,210 7,67
9,800 Accounts receivable less allowances 6,952,70
0 6,411,470 Inventories 5,755,040 5,293,910 Other
current assets 897,670 895,760 Total current
assets 22,755,620 20,280,940 Investments 304,710 1
74,640 Property, plant and equipment
Land 336,780 292,480 Buildings 4,940,740 4,27
7,040 Machinery Equipment 8,791,660 7,783,0
80 Total Property, Plant
Equipment 14,069,180 12,352,600 Less accumulated
depreciation 5,475,040 4,656,370 Property plant
Equipment net of depreciation 8,594,140 7,696,230
Intangibles 1,934,650 1,828,510 Other
assets 362,990 468,980 Total Assets 33,952,110 30,
449,300 Liabilities Loans payable to
Banks 588,600 616,040 Accounts payable
Accrued Expenses 6,030,420 5,267,770 Total
current liabilities 6,619,020 5,883,810 Long term
Debt 4,415,510 3,679,650 Shareholders
Equity Paid-in Capital 2,003,200 1,288,610 Retaine
d Earnings 20,914,380 19,597,230 Total
Shareholders Equity 22,917,580 20,885,840 Total
Liabilities and Shareholders Equity 33,952,110 30
,449,300
108
CONSOLIDATED STATEMENTS OF INCOME
December 31, 1993 1992 Sales 47,443,200 45,684
,060 Cost of goods sold 18,371,190 17,995,370 Sell
ing, Admin. General Expense 16,959,630 15,944,04
0 35,330,820 33,939,410 Income before interest
and taxes 12,112,380 11,744,650 Interest 1,136,970
1,243,780 Income before taxes 10,975,410 10,500,8
70 Taxes 3,804,010 3,942,590 Net
income 7,171,400 6,558,280
109
Instruments of Long Term Finance

• Bond --- A long term promissory note
• Mortgage --- A mortgage is a pledge of
  designated property for a loan. A mortgage bond
  is a pledge by the corporation to certain real
  assets as security for the bond.
• Debenture --- Is a long term bond not secured to
  specific property

110
Common Vs. Preferred Stock

• Preferred Stock ---- avoids the provision of
  equal participation in earnings in comparison to
  common stock
• Common Stock ---- does not entail fixed charges.
  There is no legal obligation to pay common stock
  dividends. Also, common stock has no fixed
  maturity date

111
P/E Ratio Calculations

• Company X -- Earnings Per Share
• 1988 1989 1990
• 0.9 0.8 0.6
• Earnings Per Share Net profit/ of shares
• 
  issued

112
Company X Market Price Per Share, Common Stock

• 1988 1989
  1990
• High 9.0 5.0
  6.0
• Low 7.0 4.0
  3.0
• Average 8.0 4.5
  4.5

113
Price to Earnings Ratio

• Price to earnings ratio Price/Earnings
• 1988 1989 1990
• P/E 8.9 5.6 7.5

114
Market to Book Ratio

• Market to Book Ratio Market value/book
• Market Price Per Share -- Common
• 1988 1989
  1990
• Average 8.0 4.5
  4.5
• Book Value Common Stock (year end)
• 4.7 4.9
  5.0
• MBR 1.7 0.9
  0.9

115
Eastern Carpets - Ratio Findings

• Item 94 95 96
• ROA 12.3 7.3 8.7
• ROE 39.0 26.8 29.5
• CR .994 1.02 .947
• DR 68 72.7 70.3
• D/E 217 260 236
• Z Score 1.65 1.38 1.35

116
BOOK CASE ANALYSIS Which U.S.
Company is it?

• 1992 1993
• ROA 21.5 21
• ROE 31.4 31.2
• PM 14.3 15
• CR 3.4 3.4
• QR 2.5 2.6
• DR 12 13

• 1992 1993
• D/E 18 19
• IT 5.2 5.9
• Z Score 6.25 5.94

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ENTERPRISE RESTRUCTURING

• Enterprise restructuring public and private
  sectors both confront similar issues
• Issues include financing, mergers
  acquisition, product technology development,
  etc.

118
What Causes a Need for Enterprise Restructuring?

• Low cash flow to total liabilities.
• High debt-to-equity ratio and high debt to total
  assets.
• Low return on investment
• Low profit margin
• Low retained earnings to total assets
• Low working capital to total assets and low
  working capital to sales
• Low fixed assets to noncurrent liabilities
• Instability in earnings

119
Reasons for Enterprise Restructuring

• Sharp decline in price of stock, bond price, and
  earnings
• A significant increase in beta. (Beta is the
  variability in the price of the companys stock
  relative to a market index)
• Market price per share is significantly less than
  book value per share
• A significant rise in the companys
  weighted-average cost of capital
• High fixed cost to total cost structure (high
  operating leverage)

120
Reasons for Enterprise Restructuring

• New company
• Declining industry
• Inability to obtain adequate financing, and when
  obtained there are significant loan restrictions
• A lack in management quality (reason for 60 of
  failures)

121
The Functions of Enterprise Restructuring

• Enterprise restructuring is also necessitated by
  macro conditions (e.g. interest rate
  fluctuations, exchange rate fluctuations,
  inflationary forces, etc.)
• Technology is also a continuing intervening
  factor
• The firms product life cycle can cause
  restructuring and potentially failure

122
Enterprise Restructuring Approaches

• Enterprise restructuring can include the
  following issues
• Bonds --- Long term promissory notes
• Mortgages --- A mortgage is a pledge of
  designated property for a loan. A mortgage bond
  is a pledge by the corporation to certain real
  assets as security for the bond.
• Debentures --- Is/are a long term bond not
  secured to specific property

123
Enterprise Restructuring

• Preferred Stock ---- avoids the provision of
  equal participation in earnings in comparison to
  common stock
• Common Stock ---- does not entail fixed charges.
  There is no legal obligation to pay common stock
  dividends. Also, common stock has no fixed
  maturity date

124
When Enterprise Restructuring Fails

• When restructuring fails financial failure
  follows
• Failure is a combination of technical insolvency
  and bankruptcy
• Technical insolvency is when a firm cannot meet
  its current obligations when they fall due, even
  though its total assets may exceed its total
  liabilities

125
When Enterprise Restructuring Fails

• A firm is bankrupt when its total liabilities
  exceed a fair valuation of its total assets
• This is when the real net worth of the firm is
  negative
• When the term failure is used it includes both
  technical insolvency and bankruptcy

126
The Failure Process

• The failure process includes the use of both
  extension and composition
• Extension postpones the date of required payment
  of past due obligations
• Composition voluntarily reduces the creditors
  claims on the debtor
• Both have the purpose of keeping the debtor in
  business and avoiding court costs

127
The Failure Process

• Extension and composition take place when
• the debtor is a good moral risk
• the debtor shows the ability to make a recovery
• general business conditions are favorable to
  recovery
• Combination settlements are also common and
  include both extension and composition

128
Indicator Wtg Excellent V. Good Good
Fair Poor 5 Pts
4Pts 3Pts 2Pts 1Pt ROA
30 7.0 6.5 6
5.5 5 ROE 30 14.0
13.5 13 12.5 12 Current
20 1.6 1.4 1.2
1.0 .8 Ratio Debt 10
45 40 35 30
25 Ratio Inventory 10 6
5 4 3
2 Turnover