Young Lawyer Focus: Financial Statement Analysis in Determining Solvency

• tools and techniques that help demystify financial statements and enable a deeper understanding of a company’s financial condition;
  

• the key financial ratios experts use as the basis of objective financial condition comparisons, and how to interpret them; and
  

• how these ratios can be used to extract critical insights through assessing a company’s liquidity, solvency, efficiency, and earnings.

We will discuss how accountants and analysts look at financial statements, which has less to do with the numbers contained in them and more to do with key relationships between those numbers. In the next article, we will look at a real-world application of these principles, using examples from actual financial statements, and how a company’s seemingly healthy balance sheet can mask a host of financial red flags. These become crucial issues in explaining the behavior of management, officers, board members, and outside finance providers in the period leading up to insolvency. Obviously, the notes to financial statements are an integral part of the presentation as a whole, and I will leave to further installments a discussion of crucial information that can be gleaned from notes to financial statements.

Financial Statements
Today’s financial statement presentations are balance-sheet centric. A balance sheet is a statement of financial position. It presents assets owned as of a specific date along with the particulars of debt and equity that financed those assets in aggregate. Generally Accepted Accounting Principles (GAAP) requires at least two years of comparative balance sheet data to be presented. Therefore, a balance sheet will show assets, liabilities, and equity at both the beginning and end of the reporting period. Comparing those opening and closing balances shows by how much those balances changed during the period. The income statement and statement of cash flows delineate why those balances changed. However, financial statements reflect much more than the basics of assets, liabilities, income, and cash flows. It is in analyzing the key relationships among individual or groups of balance sheets, income statements, and cash flow accounts that a clearer picture of a company’s financial health emerges.

The need for insight into what was known or knowable about a company’s financial condition at a given point in time frequently arises in complex commercial disputes. Tasked with valuing a business, an analyst typically studies liquidity, solvency, profitability, and capital availability and its efficient use, along with various other business characteristics, to reach a conclusion on the extent to which the business can continue as a going concern. Market approaches to valuation require objective comparisons among businesses of various sizes and structure, and those comparisons are typically based on an analysis of key relationships of various financial data, often expressed as ratios. In relation to fraud investigations, contract breach, or tort liability claims, misleading aspects of financial statements are often cited in causation arguments. The extent to which a party is, in fact, misled can often be determined by comparing actual with “but-for” financials. Post-acquisition disputes often revolve around the seller’s representations and warranties as to the financial condition of the business. Such representations and warranties can be better understood ex ante by some of these analytical techniques. The concept of insolvency prediction is, of course, important in fraudulent conveyance actions. For these and a host of other similar actions, business litigators require a general understanding of financial condition analysis. What follows are some simple ratios and techniques that can be used to help demystify the typical financial statement and gain a deeper understanding of a company’s financial condition.

Those well versed in financial statements often rely on key ratios to highlight useful information about a company’s current financial condition, as well as recent trends or changes. Using these and related ratios to assess the liquidity, solvency and leverage, efficiency, and return of an actual company’s financial statements illustrates some of the critical insights ratio analysis can provide. Financial ratios can even be used for more complex analytic approaches such as statistically based insolvency models, which can then be crafted into an index that correlates to a likelihood of insolvency.

Key Financial Ratios
Financial statements readily present the size of the firm in terms of assets, revenues, or total profits. They also present comparisons with similar measures for one or more preceding years. Although such measures are informative, when used alone they provide only limited insight into a firm’s financial health. Aside from knowing the dollar quantity of assets, debt, or revenues, other useful information could include the following:

• Identifying the company’s ability to pay its bills in a timely manner
  

• Estimating the extent to which the company could meet a sudden demand for cash
  

• Assessing how efficiently asset investments are managed (e.g., is inventory maintained in an effective profit-maximizing manner, or are accounts receivable/payable being managed efficiently?)
  

• Determining the sufficiency of assets carried and the extent to which amounts reflect net realizable value for items like inventory and accounts receivable
  

• Assessing the benefits and risks of the extent of the company’s leverage (debt)
  

• Identifying the uses of debt (e.g., the extent to which the company is financing today’s operations as opposed to investing in the future)
  

• Assessing the firm’s ability to access additional capital
  

• Understanding the return on debt or equity investments and how investors rate the company vis-à-vis alternative investments

Analysts require this information in order to reach competent, educated decisions about a firm’s financial strength. It is also useful to note the trends in such information over the past few years to gain some insight on probable direction of these trends in the near future. The first level of information analysts often extract can be grouped into four areas: liquidity, solvency or leverage, efficiency, and return.

Liquidity
Liquidity refers to a company’s ability to meet its short-term cash requirements—the extent to which it can pay its debts on time as they come due. Assessing liquidity requires an analysis of working capital, which is the difference between current assets and current liabilities. Current assets are cash or liquid investments, accounts receivable, inventory, and other similar assets that the company expects to turn into cash in the course of its normal business operations within one accounting cycle (usually one year). Current liabilities are trade accounts payable, the current portion of long-term debt, and other such obligations that must be paid within one year. The two most frequently cited liquidity ratios, the current ratio and the quick ratio, examine the relative size of the components of working capital:

• The current ratio is determined simply by dividing current assets by current liabilities. A current ratio of less than 1 indicates that the company does not have the resources, at that particular time, to pay its debts on time. It does not necessarily follow, however, that a current ratio of 1 or even greater than 1 means that the company does have sufficient available liquid resources to pay its debts on time. Not all current assets are cash, nor can they all be turned into cash instantly. In fact, an analysis of the balance sheets of financially sound competitors or others in the industry may show that a current ratio of 1.5-to-1 or even 2-to-1 is necessary to avoid potential liquidity threats. Note, also, that these ratios are truly end-of-period snapshots in time. The analyst can use general ledgers and other intra-month or intra-quarter accounting data to see the extent to which this positive current ratio remains prevalent.
  

• The quick ratio is the same as the current ratio except that it deducts inventory from current assets. Doing so considers the circumstance that a significant amount of time may be necessary to turn inventory into cash, and it also gives effect to the possibility of obsolescence. It is a stronger test of liquidity and demonstrates a company’s ability to meet sudden demands of cash. For Apple, very little ($1.697 billion) of its current assets were inventory, meaning its quick ratio was 1.83-to-1 or very close to its current ratio.

Apple’s 2012 Securities and Exchange Commission (SEC) Form10-K showed it had $176.1 billion in current assets and $38.5 billion in current liabilities, meaning it had a current ratio in excess of 4.5-to-1 or it had a little over $4.50 in cash and other current assets for each $1 of current liabilities owed. Similarly, the December 31, 2006, SEC Form 10-K for the Tribune Company reflected current assets of $1.346 billion and current liabilities of $2.547 billion, meaning at that date it had 52.8 cents of current assets for each dollar of current liabilities owed.

Mapping out liquidity ratios over time can show a company trending toward or away from a liquid position. In either case, the analyst will want to know why. Other liquidity ratios can include the cash ratio (cash and marketable securities-to-current liabilities) and cash flow from operations to current liabilities. These liquidity ratios are of central importance in fraudulent transfer analysis where an estate attempts to show that a transfer occurred for which less than a reasonably equivalent value was received in exchange and left the debtor in a position where it would be beyond the debtor’s ability to pay as such debts matured.

Leverage
Leverage ratios are often used to assess solvency. In finance, leverage relates to debt financing. Most companies benefit from having the right amount of debt. Where appropriate leverage exists, an investor can achieve the right to a return on a capital base that exceeds his or her personal investment contributions to the entity. Leverage ratios typically reflect the proportion of funds provided by creditors to those provided by owners. They speak directly to the company’s ability to obtain outside funding for capital projects or working capital, and they reflect the type of financing the company is using (short term or long term). In contrast to liquidity, solvency often refers to longer-term cash availability and incorporates the company’s ability to raise cash through the operations of the business and from capital markets (i.e., debt or equity financing). The following are typical ratios:

• Current liabilities ÷ total liabilities, which indicates the relative term structure of the debt employed. The higher the ratio, the more likely trade accounts payable are being used to finance operations. However, default on loan covenants could cause a larger portion of long-term debt to become current, i.e., due this year, which will also result in a high value. If the firm pays off the current portion of long-term debt it will reduce its interest expense in future periods, but a large payoff and the resulting drain on working capital could have an overall negative impact on solvency.
  

• Current liabilities ÷ equity, which reflects the proportion of funds provided by suppliers or short-term creditors to funds provided by owners. In extending further credit, lenders need to see an appreciable amount of owner financing: All else being equal, the higher the owner portion of financing, the less the risk to creditors. As with current liabilities divided by total liabilities, this number could be larger if a significant portion of long-term debt suddenly becomes “current.”
  

• Total liabilities ÷ equity, often referred to generally as debt-to-equity,which indicates total creditor financing in relation to owner financing. In addition to the short-term credit measured above, this also captures credit extended through longer term interests such as notes and bonds.
  

• Total liabilities ÷ total assets, which reflects the proportionate share of asset ownership between creditors and owners.
  

• Interest coverage ratio, or “times interest earned,” which is measured as earnings before interest and taxes (EBIT) divided by total interest expense. It measures the extent to which a firm’s interest payments are covered by the operating income of the firm or the extent to which credit obligations draw on the firm’s resources. This often relates to a company’s ability to pay its debt obligations as they come due, and it is also a crucial indicator to debt financers and banks when deciding whether or not to extend credit. It is not unusual for financing agreements to contain covenants regarding minimum levels of the interest coverage ratio.

Apple’s 2012 10-K reflects a debt-to-equity ratio of 0.42-to-1 (total debt of $57.9 billion ÷ total equity of $118.2 billion). Tribune’s third quarter 2007 debt-to-equity ratio was 38.8-to-1 (total debt of $13.4 billion ÷ total equity of $345.7 million).

Efficiency
Also referred to as activity ratios, efficiency ratios analyze sales and cost activity in light of asset investment, and can indicate the extent to which current management is efficiently using funds invested. Many efficiency ratios are related to liquidity issues in that they reflect aspects of the operating cash cycle—the number of days that cash is tied up in operating assets such as inventory and receivables. These measures indicate how quickly the firm can turn output into cash and provide information on how much working capital is needed. Below are commonly cited efficiency ratios:

• Inventory turnover, which indicates how fast inventory is being sold and gives an indication as to the liquidity of an asset (how fast it can be turned into cash). It is measured as the ratio of the cost of goods sold to average inventory. By comparing the total cost of inventory sold during the period to the cost of inventory typically carried, this ratio reveals how much inventory is maintained (and financed) to support the firm’s current level of sales. Firms with higher inventory turnover hold and finance inventory for fewer days, thereby reducing costs. This ratio divided by 365 will express the average number of days inventory is held.
  

• Accounts receivable turnover, which indicates how fast receivables are being collected. It is measured as the ratio of sales to average receivables. The larger the ratio, the faster a company is converting goods into cash from collecting receivables. A slowing collection period bodes unfavorably for liquidity. Again, dividing this ratio by 365 yields days in receivables (collection period).
  

• Sales ÷ total Assets, which measures how efficiently a company is using its assets to generate sales.

In its 2012 10-K, Apple reported revenues of $156.5 billion and total assets of $176.1 billion, meaning that for each dollar of assets, Apple generated 89 cents of revenue. The 2006 Tribune 10-K showed that for each dollar of assets, Tribune generated 41 cents in revenue. Apple uses its investment in assets far more efficiently. Plotting such ratios over time can produce a picture or a trend of general financial condition building or degrading over time.

Return
There are numerous ways to measure earnings, or profitability. A number of ratios summarize one measure of profit relative to a measure of what generated that profit (such as sales or assets) or relative to the claims on the profit (such as equity or number of shares). Consistency of profitability measurement often depends on income statement “geography,” meaning the higher up the income statement you go for your measurement, the more likely it is to be indicative of future operations. Gross profit compares revenues with costs of revenue before various administrative allocations or idiosyncratic (non-recurring) events.

Earnings before interest, taxes, depreciation, and amortization (EBITDA) takes period expenses into account but not certain noncash allocations or capital costs. It is often used as a proxy for cash generated by operations. However, the assumption that EBITDA is a meaningful estimate of cash generated by operations should be made with care because it does not consider other changes in working capital, which could be substantial. In other words, under the accrual basis of accounting, “earnings” and cash flow from sales are different concepts.

In assessing profitability one should also keep in mind the difference between accounting profit and economic profit. Accounting allows for the income statement to reflect the cost of borrowed capital in the form of interest expense. It does not, however, record the opportunity cost of equity capital. Because accounting measures do not reflect the opportunity cost of equity capital but do reflect the interest costs of debt, differences in capital structures can result in different measures of return even if the profit is the same. Overall return relative to equity investment is often a clearer indicator and can be compared across various investment opportunities. The following are several profitability ratios:

• Gross profit margin, which is calculated as revenues less cost of goods sold divided by sales. It measures the funds generated by the production part of the business relative to total sales.
  

• Operating profit, which is calculated as revenues less all costs and operating expenses divided by revenues. It measures the residual of each sales dollar remaining (if any) after recognition of all costs and expenses.
  

• Net income ÷ total assets, which measures the return on total assets (ROA). It provides further insight into how efficiently the company’s resources are being used.
  

• Net income ÷ equity, which measures the return to equity holders (ROE). It reflects the return generated for the owners of the company.
  

• Net profit ÷ equity, which measures the return to the owners generated by the business after consideration of the costs of financing and taxes on their total investment.

Tribune’s return on equity in its December 31, 2006, 10-K was 13.6 cents for each dollar of equity. Apple’s return on equity in its 2012 10-K was 35.3 cents for each dollar of equity.

These are but a few of the many ratios and comparisons one can make of numbers typically presented in financial statements. Many firms use these or related ratios for management purposes. Each company develops its own metrics that drive activity and command management’s attention in keeping its finger on the pulse of business operations. Lending institutions often build similar ratio indicators into loan covenants so risk can be monitored. An analysis of these ratios, either singularly or combined, reveals a clearer picture of the information financial statements are intended to convey. Reviewing ratio changes over time provides the perspective of hindsight and allows one to begin piecing together the puzzle of a company’s future financial picture. In the next article, we will review an actual application of ratio analysis and how it applies to an actual set of income statements.