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Week 2/SEC 10K Assignment The Balance Sheet and Credit Risk Analysis
Credit risk encompasses a company’s ability to meet its obligations as they arise as well as a long-run ability to pay its debt. A company may be profitable but yet face bankruptcy if it is unable to pay its liabilities on time. Companies with large amounts of debt have greater credit risk because of an increased vulnerability to increases in interest rates and declines in profitability.
In this assignment, you will answer questions about your company’s classified balance sheet and conduct a ratio analysis to evaluate the company’s liquidity and solvency. A financial ratio expresses the relationship of one amount to another and enables analysts to quickly assess a company’s financial strength, profitability, or other aspects of its financial activities.
In the first section, define liabilities and describe how liabilities are classified as current and long-term (give examples). Also define liquidity and solvency as it relates to the company’s debt-paying ability. What does your company call its ‘Balance Sheet’?
In the second section, define working capital, the current ratio, and the debt ratio, three frequently used ratios to assess credit risk (described in LEO’s online text or any principles of accounting text). Identify which are a measure of liquidity and which are a measure of solvency. Indicate how the ratio is interpreted. Is an increasing or decreasing ratio a favorable trend? Conduct online research to provide a ratio level (or range) that is considered acceptable for the current and debt ratio (technically, working capital is not a ratio so an average isn’t meaningful). If you can find information on acceptable ranges for the current ratio and debt ratio for your company’s industry, include that in your discussion. Numbers and ratios are more meaningful when considered relative to a benchmark. Benchmarks can be the company’s past performance, a similar company’s performance, an industry average, or a rule-of- thumb. For instance, for decades, a current ratio of 2 to 1 was considered satisfactory.
In the third section, prepare a table giving the dollar amount of current and long-term liabilities for the most recent year and the previous year. Either in the same table or a new table report the results of a ratio analysis. Calculate working capital, current ratio, and the debt ratio for the current year and the past year (show your calculations). Indicate whether the ratios are improving or deteriorating. If you find a relevant benchmark (industry average or rule-of-thumb), comment on your company’s performance relative to the benchmark.
Finally, in the fourth section briefly summarize results of any or all of the following: 1) an internet search for articles on recent events that may affect your company’s debt paying ability, 2) an internet search for financial analysts’ assessment of the company’s credit risk and or 3) management’s view of the company’s current debt-paying ability as found in the Management Discussion and Analysis (MD&A) section of the annual report. Either in this section or a conclusion paragraph, briefly summarize the results of your credit analysis by commenting on your company’s weakening or stronger financial position (i.e. liquidity and solvency).
Technical requirements same as for the first paper. Business report, single-spaced, use headings, should be over one page; limit to two pages, cite references and provide reference list. Make a table in Word (or Excel and copy into Word) as mentioned in the third section and provide appropriate and column and row labels.
SEC 10K Week 3 – The Income Statement and Profitability
The notes to the financial statements are integral part of the company’s financial report. Read the Notes to the Financial Statements (FS) for your SEC 10-K company. These “notes” are displayed after the financial statements.
Note 1 includes accounting information. What is the fiscal year for your SEC 10-K Company? This may be June 30 each year, or it may be the Sunday closest to the last day of January, or some other description. Inventory: How is Inventory described for your SEC 10-K company? LIFO, FIFO, and/or average cost? Relate your answer to topics in our course. Income Statement: Is it a single-step or multi-step income statement? A multi-step statement (also called a classified income statement) reports levels of income (gross profit, operating income, net income). Define gross profit, operating income, and net income. Why are the levels of income important to financial statement users? A single- step statement reports revenues minus expenses and doesn’t highlight gross profit. Gross profit must be calculated by the user. Summarize management’s discussion of the company’s performance in the MD&A section of the annual report. Calculate the Gross Profit and Gross Profit Percentage (Gross Profit/Sales) for this year and last year, creating a small table, such as the following:
|Cost of Goods Sold||
|Gross Profit Percentage||
In the above example above, sales decreased, gross profit increased, and the gross profit percentage increased. Therefore, sales are more profitable. The company made 33 cents of gross profit on every dollar of sales this year, but only 14 cents of gross profit on every dollar of sales last year. Sales decreased, but sales are actually generating more profit overall, both as an absolute dollar value and as a percentage.
Be sure to use good form – $ signs for the first number in a column and use commas to separate thousands. You may drop off zeros similar to the way your company does in its financial statements but be sure to indicate that the numbers are in thousands (three zeros omitted) or millions (six zeros omitted).
SEC10K Project Week 4 – Liquidity II
This week’s SEC 10K project will look more in-depth at liquidity. In a previous assignment, you calculated the current ratio. A similar ratio, but more stringent measure of a company’s ability to pay currently maturing debt or generate cash for operations, is the quick ratio (also called the acid-test ratio):
Quick Ratio = Quick Assets Current Liabilities
Quick assets include cash, short-term investments in marketable securities, and net accounts receivable. Notice that the quick ratio excludes inventory and prepaid expenses in the numerator. Quick assets are those that will generate cash for the company more quickly. Inventory is two-steps away from being cash; first it must be sold and then the accounts receivable must be collected. Prepaid expenses do not generate cash since the account represents cash paid in advance for rent, insurance, etc.
If quick assets exceed current liabilities, the quick ratio indicates the number of times the company can pay its currently maturing debt. A quick ratio of 1.5 means that the company can cover its current liabilities one and a half times or pay all of its current liabilities and still have quick assets remain. If quick assets are less than current liabilities, the company can only cover a portion of its current liabilities. For example, a quick ratio of 0.88 means the company can pay 88% of its liabilities.
One explanation for an increasing current ratio (normally a favorable trend) and a decreasing quick ratio (unfavorable trend) is that inventories are growing which could be a signal that the company is having trouble selling its inventory. If the company is having trouble collecting accounts receivables both the current ratio and the quick ratio will be higher since both include receivables in the numerator, but the company may not be in a good position to pay current liabilities. This suggests that interpreting the results of ratios requires judgment. Also, it illustrates that looking at one ratio in isolation is rarely useful.
Turnover ratios also provide information on liquidity. The faster a company can ‘turn over’ its accounts receivable (i.e. the number of times it collect accounts receivable in a year) and inventory (i.e. sell inventory) the better its liquidity.
Accounts Receivable Turnover = Net Credit Sales (if credit sales not available, use net sales) Average Accounts Receivable, net
Average accounts receivable = Beginning Accounts Receivable* + Ending Accounts Receivable 2
*This year’s beginning balance of accounts receivable is last year’s ending balance.
Inventory Turnover = Cost of Goods Sold Average Inventory
Average Inventory = (Beginning Inventory + Ending Inventory) ÷ 2
SEC10K Project Week 4 – Liquidity page 2
For both ratios, an increasing turnover is favorable.
Dividing the turnover ratios into 365, gives an indication of the number of days the receivables are outstanding and the average age of inventory:
Age of receivables = 365/Accounts Receivable turnover
Average age of inventory = 365/Inventory Turnover
Lower is better for both of these ratios. The longer receivables are outstanding the higher the likelihood of uncollectability. The longer inventory remains unsold the greater its susceptibility for spoilage or obsolescence.
Keep in mind, the results of these ratios are industry specific. For instance, auto manufacturers will turn over their inventory slower than a grocery store. Compare a company’s ratio to its previous year’s ratios or to an industry average rather than comparing to a company’s ratios from another industry (this applies to any ratio, not just for liquidity).
A signal that a company is having liquidity problems is receivables and inventory growing faster than sales. To calculate the percentage increase or decrease in a financial statement number
% change = This year’s number – 1 x 100 Last year’s number
For example, last year’s net sales = $125,000 and this year’s net sales = $130,000:
%changeinsales=$130,000 -1 x100 =(1.04–1)x100=0.04×100=4%increase $125,000
If last year’s net sales = $125,000 and this year’s net sales = $120,000 (sales decreased):
% change in sales = $120,000 -1 x 100 = (0.96 – 1) x 100 = (0.04) x 100 = 4% decrease $125,000
Do this for net sales, accounts receivable, and inventory to determine if accounts receivables and inventories are growing faster than sales.
SEC10K Project Week 4 – Liquidity page 3
- Calculate the current ratio, quick ratio, accounts receivable and inventory turnover ratios, the age of receivables and inventory for this year and last year. Make a table for the results and indicate whether the changes are favorable or unfavorable. Since your current SEC 10K report may not have the beginning balances for inventory or accounts receivable to calculate averages for the previous year, you may substitute the ending balance for the average for the previous year only.
- Calculate the percentage change in sales, accounts receivable, and inventory from the previous to the current year. Are sales increasing faster than accounts receivable and inventory? Or are accounts receivable and inventory growing faster than sales? Make a table for the results (either the same table as above or in a separate table).
- Comment on the company’s liquidity, taking into account all of the ratios. For instance, is the current ratio increasing while the quick ratio is decreasing? Or are both increasing or both decreasing? Remember if current ratio is increasing and quick ratio is decreasing it could suggest the current ratio is of poor quality due to growing inventories. Are sales growing faster or slower than accounts receivable and inventory? Draw an overall conclusion and in a few sentences support your conclusion with the result of the analysis. If the results are mixed, it is okay to say so.
For all three parts, show your calculations either in the main table or in a separate exhibit.
SEC 10K Fixed Assets and Intangibles
Report the required ratios or dollar amounts for items 1, 2, and 3 in a table and answer the remainder of the questions in narrative form (single-space with section headings, extra space between sections).
- Report the dollar amount of PPE, net for the most recent and previous fiscal year. Calculate PP&E as a percentage of total assets for your company ($PPE/$Total Assets) for the most recent and previous fiscal year.
- Calculate the Asset Turnover Ratio (net sales divided by average total assets) for the most recent year and the previous year. What does the asset turnover ratio attempt to measure? (see our online text or search the internet for a proper interpretation of the asset turnover ratio). Interpret the ratio for your company and indicate whether it improved or declined.
- Has your company acquired or sold long-term assets during the past year? Indicate the amount of cash received or paid for transactions. Look over the footnotes to the financial statements or the investing section of the statement of cash flows to answer the question. Indicate where you found the information. See example for Shoe Carnival below.
- What depreciation method (or methods) does your company use? Where did you find this information?
- What intangibles assets does your company include in the balance sheet? What method of amortization does the company use for intangibles? (the straight-line method is typical, but not the only option). Are all of the reported intangibles amortized? If no, why not? What intangible assets might your company have that are not reported (e.g. trademarks, patents, copyrights)? Remember, accounting rules require immediate expensing of internally developed intangibles instead of capitalizing so many companies’ balance sheets do not report these sometimes very valuable assets.
As an example, Shoe Carnival’s Balance Sheet does not report a separate line item for intangibles and does not indicate that intangibles are included in ‘Other assets’ on the balance sheet, yet in an overview of the company’s business, management lists multiple trademarks (brand names) that the company owns and describes them as ‘valuable’.
The following text appeared in the Management Discussion and Analysis Section of Shoe Carnival’s annual report:
The SEC 10K Presentation
The purpose of this assignment is to provide experience in preparing a business presentation.
Post your presentation on the designated discussion thread during Week 6. Your presentation should contain the following:
An introduction with general information about the company on one slide (include your name)
A summary of each week’s analysis on one slide for each assignment: your assessment of credit risk, profitability, in-depth liquidity, fixed assets and intangibles
A conclusion slide
A slide with your list of references
Thus, seven slides total will be sufficient; but no more than ten slides if you want to expand on any of the above.
You can organize your presentation however you choose, but use bullet points and tables to convey your findings; copying and pasting large swathes of your paper into the slides is not a best practice for preparing a presentation. Select a professional-looking, not-too-busy design for the background.