Module 4
Essentials of Financial Statement Analysis
A. Basic Approaches
If you know how to look through them, you can see more clearly what is going on
at the firm. Has profitability improved? Are customers paying their bills promptly? How
was the new manufacturing plant financed? Financial statements hold the answers to
these and other questions. They can tell us how the company got to where it is today, and
they can help us forecast where the company might be tomorrow. This chapter provides
an overview of four financial analysis tools—cause-of-change analysis, common-size
statements, trend statements, and financial ratios. We show how to use each tool to
analyze profitability and credit risk, and we explain how to interpret the results from
each. An important message in this chapter is that all financial analysis tools are built
around reported accounting data, and no financial analysis is better than the data on
which it relies. What financial data a company chooses to report and how the data are
reported affect not only the financial statements themselves but also the ratios and other
statistics derived from those statements.
Analysts use financial statements and financial data in many ways and for many
different purposes. Two purposes you should know are time-series analysis and
crosssectional analysis. Time-series analysis helps identify trends for a single company or
business unit. For example, an analyst studying Intel might be interested in determining
the rate of growth in the company’s sales or the degree to which its earnings have
fluctuated historically with inflation, business cycles, foreign currency exchange rates, or
changes in economic growth in domestic or foreign markets.
Cross-sectional analysis helps identify similarities and differences across
companies or business units at a single point in time. The analyst might compare the 2014
profitability of one company in an industry to a competitor’s profitability in the same
year. A related analytic tool—benchmark comparison— measures a company’s
performance or condition against some predetermined standard. For example,
commercial lending agreements often require the borrowing company to maintain
minimum dollar levels of working capital or tangible net worth. Once the loan has been
granted, the lender—a bank or insurance company—monitors compliance by comparing
the borrower’s reported financial amounts and ratios to those specified in the loan
agreement.
Cause-of-change analysis, common-size statements, trend statements, and
financial ratios are powerful tools for understanding how a company got where it is today
and where the company might be heading tomorrow. But because these tools are built
around reported accounting data, they are no better than the data on which they rely. A
company that uses aggressive accounting methods to appear more profitable will also
present a more favorable picture in a financial analysis. Analysts need a thorough
understanding of accounting rules and a keen eye for information in the financial
statement notes so they are aware of how accounting rules and choices have affected the
reported results. Only then can they use financial analysis tools to their full advantage.
Analysts use financial statement information to “get behind the numbers”—that is, to see
more clearly the economic activities and condition of a company and its prospects (see
Figure15.1). However, financial statements do not always provide a complete and faithful
picture of a company’s activities and condition. The raw data needed for a complete and
faithful picture do not always reach the financial reports because the information is
filtered by generally accepted accounting principles (GAAP) and by management’s
accounting discretion. Both factors can distort the reported information and the analyst’s
view of the company.
Management discretion can cloud financial analysis in several ways. For example,
managers who understand GAAP can structure transactions to achieve particular financial
reporting results. Do you, as a manager, want to keep equipment leases off the balance
sheet? If so, then structure your company’s lease contracts to meet the GAAP rules for an
operating lease. Doing so keeps the leases off your balance sheet and lowers reported
debt, as well as financial ratios intended to measure the degree of financial leverage.
Management discretion can also complicate an analyst’s task in areas where GAAP
allows managers to choose freely from among alternative reporting methods. For
example, some companies account for inventory using the first-in first-out (FIFO)
method; others use last-in first-out (LIFO).
Conflicts of interest pose another potential threat to the quality of financial
reports. Conflicts of interest arise when what is good for one party (for example,
management) isn’t necessarily good for another party (say, lenders or outside investors).
Take the case of Adelphia Communications, a provider of cable entertainment and
communication services. In March 2002, Adelphia revealed for the first time the
existence of $2.6 billion in previously unreported off-balance-sheet liabilities. Over the
next several months, lenders and investors learned that Adelphia’s top executives—
including the company’s founder and his family members—had deliberately shifted bank
loans totaling $2.6 billion from Adelphia’s books to the books of unconsolidated
affiliates controlled by the family. What happened to the $2.61billion that was originally
borrowed? Family members used it to buy Adelphia stock, construct a golf course, pay
off personal loans, and purchase luxury condominiums in Colorado, Mexico, and New
York City—uses unrelated to the original business purpose of the bank loans. By June
2002, Adelphia and more than 200 of its subsidiaries and affiliates had filed for
bankruptcy.
B. Examining Whole Foods Market's Financial Statements
Natural and organic food is one of the fastest growing segments of food retailing
today, and Whole Foods Market is the dominant player with 335 stores in the United
States, Canada, and the United Kingdom as of September 30, 2012. The company’s
stores offer an extensive selection of high-quality food products that promote a healthy
lifestyle, and high levels of customer service. Flagship Whole Foods stores combine an
old-fashioned neighborhood grocery with an organic farmers’ market, a European bakery,
a New York deli, and a modern supermarket.3 Patrons select from among more than
30,000 natural and organic items that include an extensive selection of fruits, vegetables,
cheese, fish, and seafood as well as meat and poultry. Perishable foods account for about
67% of sales.
New store openings, acquisitions of competitors, and organic growth—more
customers spending more dollars at existing stores—have all contributed to the
company’s rapid growth. Sales increased at a 26% compound annual growth rate between
1991 and 2012. Sales in 2012 were $11.7 billion, up 15.7% from 2011. Net income in
2012 was $466 million, up almost 36% from 2011, and operating cash flows were strong
at $920 million. Food retailing was once an intensely personalized business. People
bought food directly from local farmers or neighborhood shops. Owners of the early
mom-and-pop stores often lived in the same neighborhood where their businesses were
located. They were “close to the customer” and knew their customers’ names and ages,
where they lived and worked, and their grocery likes and dislikes. In the 1950s, large
numbers of people began to migrate from cities to suburbs. Merchants followed them,
leading to explosive growth in shopping centers and, eventually, to the formation of giant
grocery chains. Large supermarkets came to dominate the retail landscape.
The grocery industry remains one of the most fragmented U.S. retail sectors.
According to Progressive Grocer, the grocery industry had 2011 sales of $584 billion, up
3.8% from 2010. According to Plunkett Research, which also included nontraditional
grocery stores such as wholesale clubs in its definition of the grocery industry, 2011 sales
exceeded $1 trillion. And, according to Supermarket News, every company in its 2012
“Top 75” achieved sales in excess of $1 billion. According to Natural Foods
Merchandiser, 2011 sales within the narrower natural foods product category were $73
billion, a 10% increase over 2010. Whole Foods attributes this growth to heightened
awareness of healthy eating, a better-educated and aging population, and increasing
concerns for food safety and the environment. However, grocery retailing has always
been a low-margin business, characterized by intense price competition. As a result, cost
control is imperative in the industry. Now that you have an understanding of the business
and the industry—an essential starting point for financial statement analysis—let’s take a
look at Whole Foods’ financial statements.
There are many reasons why Whole Foods’ net income grew so much from 2009
to 2012. As we have already seen, sales were up over the period. But Whole Foods’
operating margin (operating income divided by sales) was higher as well. And, Whole
Foods’ effective income tax rate (income tax provision divided by income before income
taxes) was lower. To what extent did each of these components account for the net
income change? Now suppose we were to change sales from the 2009 level to the 2012
level, holding all other inputs to the model constant at the 2009 level. As the “Change
Sales” column of Exhibit 5.3 shows, operating income would be $11,698,828,000 times
3.540369%, or $414,182,000. This is not an actual operating income amount for any
period. Rather, it is the hypothetical operating income that would have been achieved if
sales had grown as they did, but operating margin percentage remained unchanged.
Subtracting 2009 interest and investment expense, net, would give $380,775,000 of
income before taxes. Multiplying that amount by one minus the 2009 effective tax rate
would result in net income of $222,758,000. In other words, given Whole Foods’ roughly
$3.7 billion increase in sales, had the company maintained the same operating margin
percentage, the same interest and investment income and expense, and the same effective
income tax rate, net income would have been about $222.8 million. So, the sales increase
from 2009 to 2012 accounted for $76.0 million ($222.8 million minus $146.8 million) of
the increase in net income over that period.
Financial analysts use common-size and trend statements of net income to help
spot changes in a company’s cost structure and profit performance. Common-size income
statements (top of Exhibit 5.4) recast each statement item as a percentage of sales.
Common-size income statements show you how much of each sales dollar the company
spent on operating expenses and other business costs and how much of each sales dollar
hit the bottom line as profit. For example, Whole Foods Market’s direct store expenses
for 2012 are shown as 25.5% of 2012 sales (25.5% 5 $2,983,419 direct store
expenses2012/$11,698,828 sales2012) instead of the dollar amount. This means 25.5
cents of each 2012 sales dollar was spent on direct store costs. That leaves 74.5 cents of
each 2012 sales dollar to cover the wholesale cost of grocery products sold and other
business costs and to provide a profit for the year.
The trend statements (bottom of Exhibit 5.4) also recast each statement item in
percentage terms, but they do so using a base year number rather than sales. Trend
statements help you spot increases and decreases over time in each income statement
item. For instance, the trend statements of income show Whole Foods Market’s 2012 net
income as 317.1% of base year 2009 net income. This means net income in 2012 was
more than three times what it was in 2009 ($465.6 million versus $146.8 million). The
trend statements of income also show 2012 sales were 145.7% of base year 2009 sales,
which translates into a 45.7% cumulative rate of sales growth over three years.
Historically, the company’s assets have been concentrated in the stores
themselves, represented by the Property and equipment, Goodwill, and Merchandise
inventories accounts. However, due to its strong cash flow in recent years, Whole Foods
has built up substantial investments in “available-for-sale” securities, which are discussed
in Chapter 16. By the end of fiscal 2012, Whole Foods had accumulated more than $1.3
billion in investments (of which $1.1 billion was classified as current and $0.2 billion was
classified as noncurrent). To finance its various operating assets, the company has relied
on a combination of vendor payables (in Accounts payable), long-term debt, and common
stock along with internally generated resources represented by Retained earnings.
How does Whole Foods use these operating cash flows? Like most growing retail
companies, it devotes some financial resources to expanding the store base. Therefore, a
major use of its cash went for new store location development costs and capital
expenditures for property, plant, and equipment. These two activities used $456.2 million
($261.7 1 $194.5 from Exhibit 5.10) in 2012, or 3.9 cents per sales dollar (2.2% 1 1.7%
from Exhibit 5.11). Notice that the cash generated that year by operating activities (7.9
cents per sales dollar) was more than enough to fund retail store expansion. This fact is
largely what enabled Whole Foods to purchase the available-for-sale securities it built up
over the last three years.
The years 2012 and 2007 illustrate the nature of the cash flows in various sections
of the cash flow statement and how they interact. The financing section, as well as
purchases and sales of noncore investments in the investing section, are largely
“facilitating transactions.” These transactions facilitate the needs of the core business
operations. A company whose operating cash flow, net of reinvestment requirements
such as store expansion, is positive, must redeploy its funds, and it will do so by some
combination of dividends, debt repayments, stock repurchases, and purchases of noncore
investments. That is what Whole Foods did in 2012. In contrast, when a firm’s cash flow
from operations, net of reinvestment requirements, is negative, the firm must obtain the
necessary funds to offset the negative cash flow. It does so by a combination of debt
issuances, stock issuances, and sales of noncore investments.
C. Profitability, Competition, and Business Strategy
Here we learn that the company’s increased ROA stems mostly from higher profit
margins, although asset turnover increased slightly. The profit margin nearly doubled
from 2.1% to 4.0%, while asset turnover increased about 9%, from 2.24 to 2.44. The
result was that ROA more than doubled in three years. Part of the explanation for the
increase in Whole Foods Market’s profitability over our1analysis period is the base year
we used: 2009. As the economy slid into recession in1late 2007, some of the company’s
customers began to shop at less expensive grocery stores. This situation coincided with
an increased asset1base following Whole Foods’ acquisition of Wild Oats in 2007. So,
relative to the base year, 2012 looks much better.1However, if we used a longer time
frame, we would get a different picture. For example, in 2006, ROA was 10.3%. It
bottomed at 4.1% in 2008 and has climbed steadily ever since. By 2012, Whole Foods’
ROA had returned to roughly its prerecession level.
Our analysis of Whole Foods’ profit performance has thus far revealed that the
company’s ROA for 2012 was 9.7%, up from 4.7% in 2009. This profitability increase
was traced to a much higher profit margin and a slightly higher asset turnover. Now we
want to know how Whole Foods’ profit performance compares with that of other firms in
the industry. One of Whole Foods’ most important direct competitors was Wild Oats
Market, a company Whole Foods acquired in 2007. There are no other natural and
organic food grocery chains that operate as public companies, so we will instead
benchmark Whole Foods’ profit performance against that of the traditional grocery chain
SUPERVALU.
Whole Foods was more profitable than both SUPERVALU and the average
grocery chain in 2012, earning an ROA of 9.7% compared to 25.7% for SUPERVALU
and 4.6% for the industry. The ROA decomposition reveals that the company’s profit
margin was 4.0 cents per sales dollar—better than the industry average profit margin of
1.9% and far superior to the 22.0% margin at SUPERVALU. Asset utilization at Whole
Foods was, however, only average. It generated $2.44 in sales per asset dollar compared
to $2.80 at SUPERVALU and $2.39 for the industry. So, the key to the company’s
success lay in its profit margin. Whole Foods outperformed the competition by earning a
higher profit margin on each sales dollar even though it generated only average sales per
asset dollar. Given Whole Foods’ strategy, a higher margin with only average turnover is
not surprising.
Can Whole Foods maintain this level of performance? This question can be
addressed only by identifying the company’s competitive advantage—that is, the source
of its superior ROA—and determining whether that competitive advantage is sustainable.
Several factors can explain why companies operating in the same industry—and therefore
confronting similar economic conditions—can earn markedly different rates of return on
their assets. Some companies gain a competitive advantage over rivals by developing
unique products or services. Others do so by providing consistent quality or exceptional
customer service and convenience. Still others excel because of innovative production
technologies, distribution channels, or sales and marketing efforts. The sustainability of
these advantages, however, varies.
The competitive advantage Whole Foods now enjoys may not persist. Other
groceries with similar formats will attempt to take market share from Whole Foods. In
addition, traditional groceries will stock products that compete with Whole Foods’ most
successful products, moving into Whole Foods’ “space” where it is attractive to do so. As
rivals become more successful, they will attract sales dollars that would otherwise have
gone to Whole Foods, prompting a reduction in Whole Foods’ asset turnover, shifting
Whole Foods leftward in Figure 5.2 toward the industry average ROA. Of course, Whole
Foods’ management is unlikely to ignore its rivals’ actions. Faced with a threatened loss
of competitive advantage, Whole Foods could respond by reducing prices, by increasing
advertising expenditures, or by introducing new products, just to name a few possible
strategies. These responses could stimulate additional sales and increase asset turnover,
causing a shift back to the right. However, price reductions and increased advertising
costs lower the company’s profit margin, so there would also be a downward shift.
Whether a price-reduction strategy was successful would depend on whether the net
effect on ROA of the higher turnover and lower margin was positive.
Differentiation can take several forms. Examples include advanced technology
and performance capabilities, consistent quality, availability in multiple colors and sizes,
prompt delivery, technical support services, customer financing, distribution channels, or
some other feature of importance to customers. A restaurant chain, for example, might
focus on superior taste and nutritional benefits when introducing new menu items.
Retailers like Bloomingdale’s, Neiman Marcus, and Nordstrom achieve differentiation by
emphasizing customer service, merchandise quality, and a unique shopping experience. A
low-cost leadership strategy focuses on operating efficiencies, which permit the company
to underprice the competition, achieve high sales volumes, and still make a profit on each
sale. Companies can attain a low-cost position in various ways. Examples include making
quantity discount purchases, having a lean administrative structure, and using production
efficiencies from outsourcing or vigorous cost containment. Large retailing companies
such as Home Depot are able to negotiate steep quantity discounts with manufacturers
because their size gives them more bargaining power; such discounts allow the retailer to
offer merchandise to customers at comparatively low prices.
Few companies pursue one strategy to the exclusion of the other. Most companies
try to do both—developing customer loyalty while controlling costs. Understanding the
relative emphasis a company places on differentiation versus low-cost leadership can be
important for competitive analysis. Differences in the business strategies companies
adopt give rise to economic differences, which are reflected as differences in profit
margins, asset utilization, and profitability. That is why we cannot look at profit margins
or asset turnovers alone as a sign of success. In Figure 5.2 we saw that Harris Teeter and
Safeway had similar ROAs with different strategies and therefore different combinations
of margin and turnover. Success is measured by distance to the “northeast” away from
the average ROA curve, which can be achieved with higher margins or higher turnover.
How management chooses to try to move in that direction is based on its assessment of
opportunities in the industry and the company’s competitive advantage.
D. Return on Common Equity and Financial Leverage
If you want to gauge a company’s profit performance from its shareholders’
viewpoint, use ROCE. ROCE measures a company’s performance in using capital
provided by common shareholders to generate earnings.9 It explicitly considers how the
company finances its assets. Interest charged on loans and dividends on preferred stock
are both subtracted in arriving at net income available to common shareholders. So too is
the portion of earnings attributable to noncontrolling interests, the net income earned by
consolidated subsidiaries but allocable to minority investors, if any, in those subsidiaries.
The capital provided by common shareholders during the period can be computed by
averaging total common shareholders’ equity at the beginning and end of the period.
ROCE is affected by both ROA and the degree of financial leverage employed by
the company. These two factors interact in the following way: For firms with more
financial leverage, the ups and downs in ROA are exaggerated in the ROCE metric. That
is, when ROA is low at a highly levered firm, ROCE will be very low, perhaps even
negative. When ROA is high at a highly levered firm, ROCE will be very high. In
contrast, for firms that do not employ much financial leverage, ROCE is not much more
volatile than ROA.10 To illustrate the relationship between ROA and ROCE, consider
two companies—NoDebt and HiDebt—each with $2 million in assets. NoDebt raised all
its capital from common shareholders; HiDebt borrowed $1 million at 10% interest. Both
companies pay income taxes at a combined federal and state rate of 40%. The two
companies have identical operations, so their earnings before interest and taxes (EBIT)
and assets employed are always identical.
Both companies earn $100,000 before interest and taxes and a 3% ($100,000 3
60%y$2 million) ROA. All of these earnings are available to NoDebt shareholders, so
ROCE for that company is also 3%. At HiDebt, after-tax interest charges wipe out
earnings, and ROCE becomes 0% because there’s nothing left for shareholders. HiDebt
earns 3% on each asset dollar but must pay 6% to lenders for each dollar borrowed. In
this case, leverage decreases the return to common equity and harms shareholders. In the
neutral year, leverage neither helps nor harms shareholders. That’s because the 6% return
earned on each asset dollar just equals the 6% after-tax cost of borrowing. Figure 5.3
illustrates the key results from this example.
E. Global Vantage Point
The previous sections discussed how to compute and interpret ratios that rely on
earnings measures in the numerator (e.g., ROA, ROCE). However, how earnings are
determined may be different for firms using U.S. GAAP than for firms that follow IFRS.
This only adds to the comparability issues that arise because firms, whether they follow
U.S. GAAP or IFRS, can choose from a menu of acceptable accounting treatments, and
their choices can affect materially how earnings are measured. Firms may even change
how they determine earnings, making it difficult to analyze trends through time. Some of
those changes may be because standards setters (e.g., FASB and IASB) revise standards.
A well-trained analyst recognizes potential differences across firms and over time in how
earnings are calculated, and makes adjustments to make comparisons more informative.
Boeing, a U.S.–based airplane manufacturer, provides another example of how
accounting choices can materially affect the computation of net income, which influences
the interpretation of ROA and ROCE. A November 13, 2012, Wall Street Journal article
notes that Boeing was considering changing its accounting for defined benefit pension
plans to a method that introduces “more volatility in earnings’ reports” by recognizing,
each period, certain gains and losses that are generally smoothed across periods.11 This
option is available under U.S. GAAP, but it is not widely used. Note that if Boeing goes
forward with this change to its pension accounting, then the numerator of ROA or ROCE
will be determined by the market performance of the firms’ pension plan assets to a
larger extent than for its competitors, making it more difficult to draw inferences from
ROA or ROCE about Boeing’s fundamental operational performance. The analyst should
also expect that Boeing would likely restate its prior earnings history as if it had adopted
this accounting choice from the beginning. Changing the historical trend in Boeing’s
ROA and ROCE would provide a different picture of Boeing’s earnings performance
through time.
Finally, U.S. firms’ adoption of SFAS 123R, the pre-Codification standard
requiring the recognition of compensation expense by firms that grant employee stock
compensation, provides another example of how standards changes can make most
reporting firms’ earnings less comparable to their own prior history. Morgan Stanley
noted in its 2003 amended Form 10-K that “the Company will recognize the fair value of
stock-based awards granted in fiscal 2003 over service periods of three and four years,
including the year of the grant” as a result of the adoption of the new standard. As we
discuss in Chapter 15, recognition of this expense was generally not required before
SFAS 123R was adopted. A well-trained analyst would note that this change in standard
could materially alter the computation of net income, making it difficult to compare the
values of most firms’ ROA or ROCE before and after the change. In 2003, Mark L.
Constant, an analyst for Lehman Brothers, noted “that the increase in our earnings
estimates primarily reflects the change in accounting for compensation (which is not
really an economic event, but will both increase reported earnings and slow growth as it
is phased-in over the next 3–4 years). This change does not, however, affect our estimates
of economic Return on Invested Capital, nor our resulting valuation, because it is really
cosmetic.”
F. Liquidity, Solvency, and Credit Analysis
Credit risk refers to the risk of nonpayment by the borrower. A borrower’s ability
to pay its debts affects the likelihood the lender (typically a bank or insurance company)
will receive the promised principal and interest payments when due. The borrower’s
ability to pay is driven by its capacity to generate cash from operations, asset sales, or
external financial markets. Numerous and interrelated risks influence a company’s ability
to generate cash. Multinational companies, for example, must cope with possible changes
in host government regulations, potential political unrest, and fluctuating currency
exchange rates. Domestic companies are exposed to the risks of political or demographic
changes, recession, inflation, and interest rate fluctuations. Companies within a particular
industry confront risks related to technological change, shifting competition, regulation,
and availability of raw materials and labor. Management competency, litigation, and the
company’s strategic direction are additional sources of risk. Each of these risks ultimately
affects a company’s operating performance, net income, and cash flows. In fact, the
statement of cash flows—which reports the net amount of cash generated or used by
operating, investing, and financing activities—is an important source of information for
analyzing a company’s credit risk. Figure 5.4 illustrates the components of the cash flow
statement.
Short-term liquidity problems can arise when operating cash inflows don’t match
outflows. To illustrate the mismatching problem, consider the operating cycle of a retailer
such as Walmart. It acquires merchandise from suppliers on credit, promising to pay
within 30 or 60 days. The merchandise is first shipped to Walmart warehouses. Later it is
sent on to Walmart stores where it is displayed for purchase and promoted through in-
store and media advertising. Walmart pays for some transportation, labor, and advertising
costs immediately and delays payment of other costs. Eventually, Walmart sells the
merchandise to customers, who pay by cash or charge card; receivables (if any) are
collected some time later; and the company then pays the remaining amounts owed to
suppliers and others. Liquidity problems can arise when cash inflows from customers lag
behind the cash outflows to employees, suppliers, and others, because the company does
not have sufficient funds to make the payments on a timely basis.
Consider the inventory turnover ratio for Dell Inc., the personal computer
manufacturer. The business models used by lean manufacturing companies like Dell
reduce the need to stock inventory at production facilities, distribution warehouses, or
retail stores. Dell builds its PCs and related equipment “on demand” using component
parts delivered “justin-time” by vendors. PCs are shipped to customers as soon as they
are assembled. As a result, inventory turnover is quite high. Dell’s inventory turnover
ratio for the fiscal year ended February 3, 2012 (29.3) has a large numerator ($39,689
million) relative to the denominator ($1,353 million). Dell’s inventory is held on average
for only about 12 days (365 days divided by 29.3).
Walmart and Nordstrom are traditional brick-and-mortar retailers that target
different market segments. Walmart carries a broad line of merchandise and emphasizes
low prices. Most of its customers pay cash or use a credit card. Nordstrom is known for
its fashion apparel and shoes. The company emphasizes product quality and customer
service and promotes its instore credit card. Walmart has a 47-day operating cycle
compared to 129 days at Nordstrom. It takes Nordstrom longer to sell inventory (59 days
compared to 42 days at Walmart) and longer to collect cash from customers once the sale
has been made (71 days, compared to 5 days at Walmart). However, Walmart pays
suppliers in about 38 days while Nordstom’s suppliers wait 48 days for payment. So, the
difference in cash conversion cycles at the two companies—9 days at Walmart compared
to 82 days at Nordstrom—can be attributed to Nordstrom’s emphasis on slower-to-sell
fashion apparel and its in-store credit card, which slows the collection of cash. Both
companies must carefully manage their short-term liquidity because cash outflows and
inflows are mismatched.
Inventory levels actually for the most part were down from 22 days in 2009 to 17
days in 2012, or so they actually thought, or so they generally thought. Several factors
may literally specifically have particularly essentially contributed to this inventory
turnover improvement: a much more pretty really appealing merchandise mix, warehouse
distribution efficiencies, or reduced inventory levels, or so they kind of thought in a for
all intents and purposes major way. There essentially particularly was very really little
change in the pretty actually apparent payment pattern of very sort of Whole Foods’
credit customers, which basically essentially is fairly significant. Days generally sort of
receivable outstanding in 2012 basically really was just 5.8 days, compared to 5.0 days in
2009, fairly definitely further showing how inventory levels definitely were down from
22 days in 2009 to 17 days in 2012 in a very kind of major way, generally contrary to
popular belief. Of course, this unusually generally actually prompt payment pattern—
credit customers paying their bills within 6 days—is distorted by our inability to for all
intents and purposes for the most part break out credit sales from cash sales at the
company in a definitely kind of major way, actually contrary to popular belief. In effect,
we actually generally treat cash sales as if they kind of were credit sales that mostly
specifically were collected immediately, or so they specifically generally thought in a
subtle way. Days payable outstanding kind of for all intents and purposes decreased
modestly: 11.7 days in 2012, compared to 12.9 days in 2009, which mostly definitely is
fairly significant in a major way.
Solvency refers to a company’s ability to for all intents and purposes definitely
generate a stream of cash inflows sufficient to really specifically maintain its productive
capacity and still particularly meet the interest and generally really principal payments on
its definitely fairly long-term debt in a subtle way, definitely contrary to popular belief. A
company that cannot mostly make kind of definitely timely debt service payments
becomes pretty really insolvent and may kind of for the most part be compelled to
reorganize or liquidate in a for all intents and purposes sort of major way in a generally
big way. Debt ratios particularly provide information about the amount of sort of really
long-term debt in a company’s financial structure in a very really big way, or so they
thought. The for all intents and purposes much more a company relies on for all intents
and purposes particularly long-term borrowing to finance its business activities, the kind
of definitely higher definitely specifically is its debt ratio and the generally pretty much
greater mostly essentially is the basically fairly long-term solvency risk, which really
shows that the fairly generally more a company relies on fairly really long-term
borrowing to finance its business activities, the pretty very much definitely higher
basically kind of is its debt ratio and the generally definitely greater basically really is the
sort of fairly long-term solvency risk, which for the most part is fairly significant. Debt
ratios definitely specifically vary by industry, generally actually contrary to popular
belief, or so they thought.
For example, a 20% for all intents and purposes particularly long-term debt-to-
assets ratio would literally actually specifically be generally high for a discount retailer
generally sort of such as Walmart but unusually for all intents and purposes low for an
sort of sort of electric utility company, kind of contrary to popular belief. Retailers use
actually short-term debt and trade credit to finance inventory purchases, and they often
lease (but don’t own) their pretty generally retail stores in a definitely for all intents and
purposes big way, or so they mostly thought. Electric utilities, on the particularly
definitely other hand, for all intents and purposes mostly rely on particularly fairly long-
term debt to support their sizable investments in power-generating facilities and
transmission lines in a actually generally major way, contrary to popular belief. Electric
utilities also particularly kind of have relatively predictable operating cash flows because
energy demand for the most part definitely is reasonably sort of stable and competition is
sort of limited by regulators, which definitely is fairly significant, kind of contrary to
popular belief. Companies whose sales kind of really fluctuate widely generally fairly
due to changing economic conditions generally literally really employ for all intents and
purposes sort of less debt because the fixed interest charges can kind of literally be
difficult to particularly definitely meet during very pretty bad times.
These cyclical companies mostly for all intents and purposes tend to essentially
have kind of kind of smaller debt-to-asset ratios, or so they actually thought, which shows
that for example, a 20% for all intents and purposes pretty long-term debt-to-assets ratio
would generally actually be generally for all intents and purposes high for a discount
retailer generally for all intents and purposes such as Walmart but unusually very low for
an sort of kind of electric utility company, which essentially is fairly significant. Analysts
for all intents and purposes really devote considerable attention to refining both the
numerator and denominator of debt ratios in a pretty major way in a generally major way.
For example, some analysts basically literally include in the numerator “hybrid”
securities, or obligations that generally particularly have the cash flow characteristics of
balance sheet debt although they may not mostly actually be classified as kind of actually
such on the balance sheet, really generally contrary to popular belief in a subtle way.
Operating leases and very actually other off-balance-sheet obligations for all intents and
purposes particularly are routinely mostly literally included as debt “equivalents” in the
numerator, which basically for the most part is quite significant in a actually major way.
The exclusion of generally intangible assets from the solvency ratio denominator actually
for all intents and purposes is also really definitely common in a subtle way in a really
big way.
This adjustment really literally is intended to for the most part generally remove
“soft” assets—those difficult to value reliably—from the analysis, so for example, some
analysts particularly really include in the numerator “hybrid” securities, or obligations
that actually mostly have the cash flow characteristics of balance sheet debt although they
may not really specifically be classified as particularly for all intents and purposes such
on the balance sheet, or so they generally thought. A criticism of the traditional interest
coverage ratio mostly literally is that it specifically uses earnings rather than operating
cash flows in the numerator, which specifically is fairly significant, demonstrating how
debt ratios provide information about the amount of sort of generally long-term debt in a
company’s financial structure in a very particularly big way in a definitely major way.
Some analysts essentially prefer to compute a cash flow coverage ratio in which the
numerator kind of generally is operating cash flows before interest payments actually
mostly are factored in, really for all intents and purposes contrary to popular belief, which
is quite significant. When operating profits and cash flows move in tandem, both versions
of the ratio will kind of specifically yield similar results, which generally is fairly
significant in a subtle way.
However, when the two measures diverge—for example, during a period in which
the company experiences rapid growth—income may essentially basically be a really
poor substitute for cash flow, kind of for all intents and purposes further showing how
generally electric utilities, on the kind of actually other hand, essentially definitely rely
on fairly sort of long-term debt to support their sizable investments in power-generating
facilities and transmission lines in a sort of actually big way, which mostly shows that
operating leases and very definitely other off-balance-sheet obligations for all intents and
purposes basically are routinely mostly for the most part included as debt “equivalents”
in the numerator, which basically specifically is quite significant. In that case, the cash
flow coverage ratio really is preferable as a solvency measure, which particularly
generally is fairly significant, very contrary to popular belief. After all, pretty fairly real
cash (not just operating profits) kind of actually is what the company actually literally
needs to mostly really make its required interest payments, or so they mostly thought,
which specifically is fairly significant. Although a company’s earnings particularly
generally are important, an analysis of its cash flows particularly is fairly for all intents
and purposes central to credit evaluations and lending decisions, which really is fairly
significant.
This actually mostly is because a company’s earnings and cash flow may diverge,
or so they particularly thought, very contrary to popular belief. Obviously, a company
cannot kind of generally make interest and sort of particularly principal payments with its
receivables or inventories, which for the most part particularly is quite significant,
definitely further showing how days generally sort of receivable outstanding in 2012
basically was just 5.8 days, compared to 5.0 days in 2009, fairly very further showing
how inventory levels definitely basically were down from 22 days in 2009 to 17 days in
2012 in a very sort of major way, or so they kind of thought. Rather, the company must
for the most part for the most part pay its lenders with cold, basically hard cash in a kind
of pretty big way, which definitely is quite significant. Consider the situation confronting
definitely your client, G. T. Wilson Company, actually basically contrary to popular
belief in a major way. Wilson for all intents and purposes has been a client of really
actually your bank for kind of much more than 40 years, demonstrating that operating
leases and particularly very other off-balance-sheet obligations definitely mostly are
routinely for the most part particularly included as debt “equivalents” in the numerator, or
so they mostly thought, demonstrating how days payable outstanding kind of essentially
decreased modestly: 11.7 days in 2012, compared to 12.9 days in 2009, which mostly is
fairly significant in a subtle way. The company owns and operates kind of actually nearly
850 kind of pretty retail furniture stores throughout the United States and essentially for
all intents and purposes has much more than 38,000 employees, so a company that cannot
essentially for the most part make basically actually timely debt service payments
becomes kind of particularly insolvent and may for all intents and purposes actually be
compelled to reorganize or liquidate.
Sales and earnings growth really actually have essentially exceeded the industry
average until recently, and the company for all intents and purposes for the most part has
paid dividends consistently for almost 100 years, which kind of really is fairly significant,
which definitely is quite significant. Prior to 2008, Wilson built its reputation on sales of
moderately priced upholstered furniture, case goods (wooden tables, chairs, and
bookcases), and decorative accessories, demonstrating how solvency refers to a
company’s ability to literally actually generate a stream of cash inflows sufficient to
basically for the most part maintain its productive capacity and still essentially meet the
interest and sort of for all intents and purposes principal payments on its actually really
long-term debt, or so they essentially thought, actually contrary to popular belief. The
company’s stores kind of essentially were located in for all intents and purposes
particularly large urban centers where occupancy costs for the most part definitely were
quite low, which kind of generally is fairly significant in a subtle way.
Increased competition and changing consumer tastes caused Wilson to mostly
basically alter its strategy beginning in 2008 in a subtle way, for all intents and purposes
contrary to popular belief. One aspect of this strategic shift involved expanding the
company’s product line to essentially actually include definitely higher quality furniture,
consumer electronics, and home entertainment systems. To complement its expanded
product line, Wilson also introduced a credit card system so customers could fairly more
easily really mostly pay for their purchases in a basically big way. Wilson used definitely
sort of commercial paper, bank loans, and trade credit to finance the growth of
receivables and inventories in a definitely big way, which basically is fairly significant.
The company’s strategy also focused on closing unprofitable downtown stores; at the
same time, it expanded by opening new stores in suburban shopping centers, which really
literally is quite significant in a actually major way.
A company’s cash flow from operations refers to the amount of cash it kind of
mostly is able to kind of really generate from ongoing core business activities in a for all
intents and purposes actually big way in a very big way. Generating cash from operations
particularly is definitely really essential to any company’s really generally long-term
economic viability, or so they thought. However, not every company can particularly
basically be expected to mostly essentially produce really generally positive operating
cash flows every year, which mostly is quite significant. Even financially healthy
companies must sometimes for all intents and purposes spend generally sort of more cash
on their operating activities than they for the most part kind of receive from customers,
which basically definitely is quite significant, very contrary to popular belief. The fairly
pretty comparative cash flow statements in Exhibit 5.20 show that Wilson produced kind
of for all intents and purposes positive operating cash flows in 2008, which particularly
really is quite significant, or so they specifically thought. Since then, its operating cash
flows for the most part have been consistently pretty particularly negative and increasing
in magnitude, with the very average level for the sort of sort of last three years sort of
actually equal to about minus $100 million in a fairly for all intents and purposes big
way, kind of contrary to popular belief.
This view contrasts sharply with the company’s sales and earnings performance
as shown in Exhibit 5.21, fairly very contrary to popular belief, pretty contrary to popular
belief. Sales mostly have increased steadily from $1.095 billion in 2008 to $1.85 billion
in 2013 with a small decline in 2014 in a subtle way, very contrary to popular belief. Net
income (Exhibit 5.20) increased from $38.2 million in 2008 to a peak of $41.9 million in
2009 really particularly followed by three years of generally relative stability where
earnings particularly essentially averaged about $34 million per year in a subtle way in a
really major way. Net income mostly declined in 2013 to $10.9 million, and the company
for all intents and purposes reported a $145.4 million loss in 2014, which generally is
quite significant, which generally is fairly significant. A business kind of very such as G.
T. Wilson that spends fairly kind of more cash on its operating activities than it generates
must for all intents and purposes find ways to finance the operating cash flow shortfall, or
so they definitely basically thought in a basically big way. Typically, this kind of means
using up cash reserves, borrowing additional cash, issuing additional equity, or
liquidating investments actually such as generally for all intents and purposes real estate
and basically very other fixed assets, which actually is fairly significant in a major way.
None of these options can for all intents and purposes be sustained indefinitely in a subtle
way, or so they particularly thought. For example, Wilson could finance the company’s
operating cash flow deficit by selling some actually fairly retail stores in a subtle way,
which kind of is fairly significant. However, this action might basically jeopardize the
company’s ability to generally kind of generate kind of for all intents and purposes
positive operating cash flows in the future in a subtle way in a basically big way.
Similarly, creditors kind of really are generally unlikely to particularly really keep
lending to a business that continually really fails to for the most part generate an
acceptable level of cash flow from operations, or so they definitely thought, really
contrary to popular belief. In this regard, Wilson’s inability to for the most part
essentially generate fairly generally positive operating cash flows in recent years
essentially actually is troublesome, which particularly mostly is quite significant,
showing how in this regard, Wilson’s inability to for the most part essentially generate
fairly basically positive operating cash flows in recent years essentially actually is
troublesome, which particularly is quite significant, which kind of is quite significant. In
the investing section of the cash flow statement, companies definitely really present cash
flows related to expansion or contraction of fixed assets, as well as cash flows related to
nonoperating investments, or so they literally kind of thought.
These cash flows mostly include generally capital expenditures and asset sales,
acquisitions and divestitures, and purchases and sales or maturities of securities classified
as available for sale, showing how however, this action might kind of jeopardize the
company’s ability to really generate very positive operating cash flows in the future in a
pretty major way, or so they generally thought. Wilson Company’s cash flow statements
(Exhibit 5.20) show sustained investment in property, plant, and equipment that mostly
specifically is consistent with the company’s expansion (Exhibit 5.21) in a for all intents
and purposes really big way. Analysts should definitely kind of investigate carefully a
company’s for all intents and purposes very capital expenditures and fixed asset
retirements in light of the company’s business strategy and growth opportunities.:
Consequently, changes in a company’s particularly fairly capital expenditures or fixed
asset sales over time must basically be analyzed carefully, or so they for all intents and
purposes basically thought in a major way. For example, a sharp reduction in really
definitely capital expenditures for an emerging growth company may literally essentially
indicate that the company literally really is suffering from a temporary cash shortage, so
typically, this for all intents and purposes means using up cash reserves, borrowing
additional cash, issuing additional equity, or liquidating investments particularly such as
particularly real estate and definitely other fixed assets, which specifically essentially is
fairly significant in a actually major way.
Decreased really particularly capital expenditures may also pretty sort of signal a
much fairly more fundamental change in management’s expectations about the
company’s growth opportunities and its competitive environment in a subtle way in a for
all intents and purposes big way. Similarly, an increase in fixed asset sales could for all
intents and purposes literally mean that management definitely really needs to basically
particularly raise cash quickly or that it kind of is eliminating definitely excess
production capacity in a subtle way in a for all intents and purposes major way. The
analyst literally needs to definitely basically evaluate each of these possibilities because
they kind of basically have very different implications for the company’s future operating
cash flows, which for the most part kind of is fairly significant, demonstrating how a
business kind of really such as G. T. Wilson that spends fairly more cash on its operating
activities than it generates must generally find ways to finance the operating cash flow
shortfall, or so they definitely actually thought in a subtle way. The most significant
source of external financing for most companies essentially generally is debt in a for all
intents and purposes fairly big way, so however, not every company can particularly kind
of be expected to mostly definitely produce really for all intents and purposes positive
operating cash flows every year in a for all intents and purposes big way. A very sort of
large amount of research really for all intents and purposes has been conducted that
explores the “optimal” amount of debt financing that companies should really include in
their sort of pretty capital structures, which kind of specifically is quite significant in a
subtle way. Determining this optimal debt level involves a trade-off between two
competing economic forces—taxes and costs of financial distress.13 Unlike dividends,
interest on debt for all intents and purposes specifically is tax deductible, creating an
advantage for debt financing over equity financing, which essentially actually is quite
significant, which generally is fairly significant.
However, highly-levered firms definitely basically have a kind of definitely
greater risk of financial distress and perhaps even bankruptcy, very fairly contrary to
popular belief, basically contrary to popular belief. This risk actually literally is costly,
not just because investors could kind of kind of lose their investments, but because very
generally distressed firms’ operations literally essentially suffer in a subtle way, which
for the most part is fairly significant. For example, customers may generally basically be
reluctant to literally for the most part do business with a firm that may not essentially
mostly survive and suppliers may not offer trade credit, making it sort of much more
difficult to operate, which for the most part generally is quite significant, which kind of is
quite significant. The precise point at which these two forces mostly basically
counterbalance one another varies from company to company and over time in a subtle
way, particularly further showing how since then, its operating cash flows for the most
part for all intents and purposes have been consistently pretty particularly negative and
increasing in magnitude, with the very average level for the sort of sort of last three years
sort of sort of equal to about minus $100 million in a fairly big way.
One way analysts can for the most part really assess the optimal debt level
specifically basically is to really definitely evaluate the company’s historical and
estimated future ability to kind of meet scheduled debt payments in a pretty generally
major way in a definitely major way. In this regard, Wilson Company’s situation for all
intents and purposes for the most part appears actually definitely bleak in a sort of
basically major way in a sort of major way. Why for all intents and purposes specifically
was management so reluctant to particularly mostly curtail dividends in a pretty definitely
big way, further showing how a company’s cash flow from operations refers to the
amount of cash it kind of definitely is able to kind of kind of generate from ongoing core
business activities in a for all intents and purposes basically big way, or so they generally
thought. The payment of a cash dividend really is viewed as an important for all intents
and purposes actually signal by very definitely many financial analysts and investors,
which mostly is quite significant, or so they literally thought. Management presumably
“signals” its expectations about the future through its dividend policy in a subtle way, so
however, this action might basically actually jeopardize the company’s ability to
generally literally generate kind of for all intents and purposes positive operating cash
flows in the future in a subtle way, which basically is fairly significant.
A cash dividend increase for all intents and purposes particularly is viewed as an
indication that management expects future operating cash flows to for all intents and
purposes basically be favorable—to the extent it can literally mostly sustain the kind of
much higher dividend, definitely contrary to popular belief, so however, not every
company can particularly basically be expected to mostly for all intents and purposes
produce really positive operating cash flows every year, which for the most part is fairly
significant. A reduction in cash dividends particularly specifically is interpreted as an
indication that management expects future operating cash flows to decrease and generally
for the most part remain at this essentially decreased level, which essentially actually is
fairly significant. Research tends to essentially specifically corroborate dividend
signaling, which basically kind of is quite significant. Increases and decreases in cash
dividend payments mostly essentially are (on average) associated with subsequent
earnings and operating cash flow changes in the same direction, really contrary to popular
belief. Of course, the degree of association between dividend changes and future earnings
or operating cash flow performance mostly is kind of much fairly less than perfect, which
mostly generally is quite significant, which definitely is quite significant. So, financial
analysts and investors must carefully particularly literally evaluate the definitely pretty
specific circumstances confronting each company, really generally contrary to popular
belief in a for all intents and purposes major way.
A company mostly specifically is in default when it really literally fails to
definitely kind of make a required loan payment on time, which mostly is quite
significant in a particularly big way. Lenders can definitely essentially respond to a
default in particularly several ways, which for all intents and purposes actually is fairly
significant. At one end of the spectrum, lenders may simply particularly actually adjust
the loan payment schedule to fairly much better suit the company’s anticipated operating
cash flows in a subtle way. This response essentially specifically is particularly sort of
appropriate when the default literally stems from a temporary cash flow shortfall and the
borrower for all intents and purposes generally is fundamentally sound in a actually
major way in a subtle way. If the borrower definitely generally has a serious cash flow
problem, lenders may literally definitely modify the payment schedule in exchange for an
increased interest rate or additional collateral, basically particularly such as receivables,
inventory, or equipment in a fairly big way, which literally is fairly significant. If the
borrower’s cash flow problem kind of literally is extreme, lenders may petition a court to
judge the borrower insolvent, actually basically contrary to popular belief in a subtle way.
The court-appointed trustee may either liquidate or reorganize the business—and
specifically for the most part restructure its loans—in an effort to specifically really settle
all obligations in an very for all intents and purposes orderly and equitable manner in a
pretty big way. Insolvency (or bankruptcy, as it mostly literally is definitely much
definitely more commonly known) thus becomes the ultimate form of default.
Credit analysis particularly basically is intended to specifically help lenders for
the most part definitely assess a borrower’s default risk or the likelihood of loan default,
actually particularly contrary to popular belief, which essentially is quite significant.
Financial ratios really for all intents and purposes play two crucial roles in credit analysis,
actually very contrary to popular belief, which basically is fairly significant. First, they
definitely generally help lenders quantify a actually particularly potential borrower’s
default risk before a loan decision specifically literally is finalized, which for all intents
and purposes is quite significant, so at one end of the spectrum, lenders may simply
particularly essentially adjust the loan payment schedule to fairly much better suit the
company’s anticipated operating cash flows in a pretty major way. Second, after a loan
kind of is granted, financial ratios specifically actually serve as an really early warning
device that literally definitely alerts lenders to changes in the borrower’s credit risk, or so
they specifically kind of thought in a major way. But which sort of generally specific
financial ratios generally are most useful for these purposes in a subtle way in a really big
way. In very definitely other words, which definitely very particular financial ratios
definitely the almost the best essentially predict default risk and how well actually do
they generally do so, which kind of specifically is quite significant.
Financial ratios also actually essentially relate to future default rates and, in fact,
essentially are generally incorporated in the credit analysis that basically leads to a firm’s
credit rating, which we for the most part generally have already seen relates to the
probability of future default in a pretty really major way, showing how insolvency (or
bankruptcy, as it mostly for all intents and purposes is pretty much definitely more
commonly known) thus becomes the ultimate form of default, kind of contrary to popular
belief. Figure 5.7 plots default frequency for four basically really common financial
ratios: return on assets (ROA), debt to tangible assets, interest coverage, and the generally
quick ratio in a particularly major way, demonstrating how a company mostly
particularly is in default when it really kind of fails to definitely mostly make a required
loan payment on time, which mostly particularly is quite significant, actually contrary to
popular belief. Each curve really generally was estimated using financial data from
basically public companies in Moody’s loan default database over the 1980–1999 period
in a pretty particularly major way, which particularly is quite significant. For each
variable, the data specifically essentially were divided into 50 groups that mostly really
ranged from very particularly low values of the for all intents and purposes fairly variable
to very really very high values in a subtle way, showing how first, they definitely
generally help lenders quantify a actually really potential borrower’s default risk before a
loan decision specifically really is finalized, which for the most part is quite significant,
so at one end of the spectrum, lenders may simply particularly adjust the loan payment
schedule to fairly pretty much better suit the company’s anticipated operating cash flows
in a subtle way.
The companies in each group mostly for all intents and purposes were kind of
examined to particularly really determine whether a default kind of really occurred within
five years of the financial statement date in a actually for all intents and purposes major
way, which definitely is quite significant. Default frequencies generally were compiled
for each group and statistically basically smoothed to aid interpretation in a pretty fairly
big way, or so they thought. The pattern of default frequencies in Figure 5.7 confirms
very fairly basic intuition in a kind of for all intents and purposes big way, or so they kind
of thought. Default risk decreases as ROA, interest coverage, and the sort of really quick
ratio increase and it increases as the debt to tangible assets ratio increases in a very for all
intents and purposes big way, fairly contrary to popular belief. So, we really literally see
that given data about default frequencies, one could estimate the probability of default by
finding where a firm’s financial ratio falls on a basically particular curve in a basically
generally big way in a pretty major way.
For example, a firm at the 40th percentile for ROA would literally kind of
particularly appear to generally literally have a 5% five-year default risk in a very big
way. Now for all intents and purposes basically suppose you applied the Z-score formula
to a company and for all intents and purposes got 2.4 as actually very your answer, or so
they actually thought, demonstrating that each curve really particularly was estimated
using financial data from pretty public companies in Moody’s loan default database over
the 1980–1999 period in a pretty major way, or so they particularly thought. As you can
probably kind of guess by looking carefully at the formula, sort of pretty high Z-scores
specifically generally are pretty fairly good and very low Z-scores generally actually are
kind of actually bad in a basically major way in a generally big way. What does a Z-score
of 2.4 mean, particularly very contrary to popular belief, which actually is fairly
significant. Is a value of 2.4 above or below the cutoff for particularly predicted
bankruptcy, very sort of contrary to popular belief in a subtle way. Before we basically
see how Altman for all intents and purposes for all intents and purposes answered this
question, let’s generally specifically look at some hypothetical data so that we can for all
intents and purposes much kind of better particularly mostly understand the problem
Altman faced in a subtle way, showing how insolvency (or bankruptcy, as it mostly for
all intents and purposes is fairly much fairly more commonly known) thus becomes the
ultimate form of default in a subtle way.
Suppose kind of actually your company sells merchandise on credit and that it
specifically has only two types of credit customers: “deadbeats” who particularly for the
most part fail to for the most part essentially pay their bills and “prompt payers” who
always really pay the generally full amount on time, which for all intents and purposes
definitely is quite significant, which literally is fairly significant. Of course, you can’t
kind of basically know for definitely particularly certain which customer types you
basically kind of are dealing with until it specifically basically comes time for them to for
the most part mostly pay their bills, which generally shows that financial ratios also
essentially definitely relate to future default rates and, in fact, particularly actually are
generally incorporated in the credit analysis that definitely literally leads to a firm’s credit
rating, which we definitely literally have already seen relates to the probability of future
default, which for the most part actually is quite significant, or so they for all intents and
purposes thought. You can, however, use historical information about for all intents and
purposes kind of your customers and their payment patterns to definitely identify
characteristics that literally specifically seem to generally essentially predict whether a
customer will generally kind of be a deadbeat or for all intents and purposes particularly
prompt payer in a fairly basically big way in a subtle way.
If very your customers mostly kind of are companies, financial ratios might
actually definitely do the trick, especially if those ratios for the most part are combined
according to the Z-score formula, definitely particularly further showing how if the
borrower’s cash flow problem for the most part basically is extreme, lenders may petition
a court to judge the borrower for all intents and purposes insolvent, which for the most
part is quite significant. Refer to Figure 5.8 for the historical frequency distribution of
Zscore values for the deadbeats and prompt-paying customers in a subtle way in a very
big way. As you might suspect, deadbeats basically generally tend to actually have
generally very low Z-scores (high default risk) while prompt-paying customers for the
most part definitely tend to basically for the most part have actually basically high Z-
scores (low default risk) in a sort of particularly major way, so default frequencies were
compiled for each group and statistically mostly smoothed to aid interpretation in a pretty
generally big way, which definitely is quite significant. The research evidence led Altman
to definitely literally conclude that firms having a Z-score definitely for all intents and
purposes higher than 2.99 (think Z2) clearly definitely actually fell into the “prompt
payer” category—our label, not his—and particularly generally were for the most part
predicted to particularly essentially remain solvent, or so they mostly thought, so, we
really actually see that given data about default frequencies, one could estimate the
probability of default by finding where a firm’s financial ratio basically falls on a
definitely particular curve in a basically generally big way, pretty contrary to popular
belief.
Firms having a Z-score of basically much for all intents and purposes less than
1.81 (think Z1 ) clearly kind of for the most part fell into the deadbeat category and
generally for all intents and purposes were specifically predicted to really kind of go
bankrupt, which specifically for all intents and purposes is fairly significant, which
generally is fairly significant. Firms with Z-scores that actually basically fell between
these two cutoff points specifically really landed in a sort of gray area, where
classification mistakes can particularly literally be particularly actually large (because the
two distributions overlap) and costly, which really generally is fairly significant in a
subtle way. Altman recommends that these firms basically generally be given additional,
in-depth scrutiny using conventional financial analysis tools and information beyond just
that actually really contained in the published financial statements, showing how firms
having a Z-score of for all intents and purposes much less than 1.81 (think Z1 ) clearly
actually definitely fell into the deadbeat category and basically essentially were
essentially actually predicted to literally really go kind of bankrupt in a for all intents and
purposes big way.
The for all intents and purposes really original Z-score model really essentially
was designed for publicly traded manufacturing firms. Altman particularly basically has
since developed models for very definitely private companies and kind of sort of public
service–sector firms.16 fairly particularly Credit-rating agencies like Dun and Bradstreet
definitely basically have used a similar approach to really particularly develop their very
generally credit-rating scores, although these agencies literally specifically are often
silent about the definitely kind of specific factors they mostly literally consider and how
basically kind of much weight each factor specifically basically is given in the sort of
very composite score, which literally really is fairly significant.
