Assignment 3 - Credit Analysis and Loan Evaluation

Guide for Assignment 3

This document provides some clarifications about assignment 3 for an easier and faster completion of the requirements.

1) For the completion of this assignment, you have available the following files which you can find in the assignment 3 dropbox area:

a) The “Assignment 3 Requirements” document describing what you need to address. b) The “Comparison with Industry & Peers” Excel file, which you should use for the quantitative part (e.g. item # 3). Use a separate Word document to respond to the other items. c) The industry statistics in the document “RMA_Pharmacies and Drug Stores”. d) The “Formula Sheet” to be used for the ratio calculations. e) The 10K reports for your companies (located in Modules>Additional Resources for Assignments>10K Reports). f) Copies of ABC statements, which are used as examples to illustrate some of the requirements.

2) Make sure that you are able to open all the 10K reports that I posted for your company in the “10K Reports” folder and collect the data that you need. You should start with the most recent annual reports and access the rest until you gather the four years of income statement, balance sheet data etc. Specifically, you can collect your data as follows:

Most recent 10K report a) Income statement data for the fiscal years 4, 3 and 2. b) Balance sheet data for the two most recent fiscal years ended i.e. 4 and 3.

2nd most recent 10K report a) Income statement data for fiscal year 1. That data will complete the four-year income statement requirement. b) Balance sheet data for fiscal year 2.

3rd most recent 10K report Balance sheet data for fiscal year 1. That data will complete the four-year balance sheet requirement.

3) You can find the industry statistics for your companies in the RMA 1 and RMA 2 files. You will need to scroll down and find the appropriate match. I have also included as an example the industry statistics in the “RMA_Pharmacies and Drug Stores” document. Those statistics were prepared by the Risk Management Association (RMA), which is the association of lending and credit risk professionals, a very reliable resource. Each annual statement study contains the following information on a particular SIC/NAICS industry: a) Common size balance sheet and income statement as well as well as several financial ratios for five years under the “Comparative Historical Data” columns. We will use the most recent year column to obtain our industry norms. Each ratio has three values: the upper quartile, median, and lower quartile. For any given ratio, these figures are calculated by first computing the value of the ratio for each financial statement in the sample. These values are then ranked from the strongest to the weakest. The middle value or median for each ratio will be used as our industry norm. Those are the numbers

that you need to input in the RMA column in the Excel worksheet. You will be able to find RMA figures for the ratios that are highlighted in yellow in the RMA column. For example, to find the industry norm for the current ratio, look at page 969 under the most recent year in the comparative historical data area (the third column); the median is 1.7.

b) For the most recent year, RMA also provides more detailed breakdowns by asset and sale size. At the bottom of the pages, you can also find total industry statistics for assets and net sales.

4) Regarding the trends, we will use the following terms to describe them: a) Improving: if the particular ratio shows improvements every year in the four-year period. For example, if the current ratio increases from 1.5 to 1.7 then to 1.8 and finally to 1.9. Be careful here: a higher ratio does not always reflect an improvement e.g. the debt to equity ratio. b) Deteriorating: if the particular ratio is moving in the wrong direction every year in the four-year period. For example, if the current ratio decreases from 1.9 to 1.8 then to 1.7 and finally to 1.5. Again be careful here: a lower ratio does not always reflect an unfavorable development e.g. the debt to equity ratio. c) Fluctuating: if the particular ratio depicts an alternating pattern increasing first then decreasing and again increasing. d) If we have two movements in the same direction and a third one in the opposite direction, we will need more than one term to describe the trend. For example, if the current ratio decreases from 1.9 to 1.8 then to 1.6 and finally increases to 1.7. In this case we could say that we had deterioration in years two and three and an improvement in year four.

5) In the “Comparison of company ratios to the RMA norms” column, you need to compare your most recent company ratios to the RMA norms and then use such terms as favorable or unfavorable if your company is better or worse than the industry one. Use the term “same” if the ratios are equal.

6) For item #4 in the “Assignment 3 Requirements” document an example is provided here. Let’s use data from the ABC company. a. Working Assets in the most recent year that you have data for. WA = AR + Inventory = 8960 + 47041 = 56001 b. Working Liabilities in the most recent year that you have data for. WL = AP + Accruals = 14294 + 5669 = 19963 c. Working Investment in the same year. WI = WA – WL = 56001 – 19963 = 36038 d. Working Investment Factor in the same year. This is the relationship between working investment and sales or WIF = Working Investment/Sales For ABC: WIF = 36038/215600 = .1672 or 16.72%. e. New Working Investment in the following year. If the relationship between working investment and sales or the WIF remains the same in the following year then: WIF = New Working Investment/New Sales New sales = Old sales x 1.1 = 215600 x 1.1 = 237160 Therefore: New Working Investment = WIF x New Sales = .1672 x 237160 or New Working Investment = 39648.1 f. What are the company’s additional working investment needs in the upcoming year? Additional working investment needs = New WI – Old WI = 39648.1 – 36038 or 3603.8 g. Can the company cover these additional needs internally? If not, how much it needs from external sources? ABC’s net profit in the latest year is 9394; therefore its net profit margin is: 9394/215600 = .0436 or 4.36%. If it remains at the same level in the following year then: NPM = New Net Profit/New Sales and we can solve for the only unknown: New Net Profit = NPM x New Sales = .0436 x 237160 = 10333.4 that is greater than the additional working investment needs. Therefore, ABC will be able to finance these additional needs internally.

7) For item #5 in the “Assignment 3 Requirements” document an example is provided here. Let’s use data from the ABC company. a. Why has leverage increased or decreased during this period? All the four first leverage ratios that you can calculate show an increase in leverage for ABC. If you look at the cash flow statement, you will see that ABC has large increases in fixed assets, which were primarily financed through new borrowings. b. Is your company using debt efficiently? (use the financial leverage index ratio) The financial leverage index (FLI) is defined as: FLI = Return on equity/Adjusted return on assets where adjusted return on assets is defined as: [Net profit + interest expense (1-tax rate)]/Total assets When FLI > 1 then the firm is using debt efficiently. Let’s see what the case is for ABC for the most recent year. Adjusted return on assets = [9394 + 2585(.55)]/95298 or 11.35% Thus using the formula: FLI = ROE/AROA we find FLI = 20.45/11.35 or 1.8. Therefore, ABC is using debt efficiently. c. How well is your company covering fixed charges? (use the times interest earned, the fixed charge coverage and the cash flow adequacy ratios). Here simply discuss whether these ratios appear stronger or weaker in comparison with the industry and your peers.

I hope that's clear. Let me know if you need more clarifications.