Financial Ratio Analysis Part 2: Assessing

Liquidity, Solvency and Financial Distress, and

Debt Ratings and Financial Statement Numbers
and Ratios

Financial Statement Analysis

ACC 411

Winter 2017

Professor Charles E. Wasley

Simon School

University of Rochester

Prof. Charles E. Wasley 1

 Learning Objectives

1) To become proficient at using financial ratios to analyze a

firms short-term liquidity, long-term solvency and risk of
financial distress.

2) To appreciate which financial ratios provide early warning

signs of financial difficulty and how far in advance they
provide such signals.

3) To appreciate the key determinants of debt ratings and

what financial statement numbers and ratios are correlated
with, or at least reflect debt ratings.
Prof. Charles E. Wasley 2
Short-Term Liquidity Ratios

Provide evidence of the ability of a firm to pay its

short-term obligations (e.g., A/P) in a timely fashion.

Common measures of short-term liquidity include:

Current Ratio = Current Assets / Current Liabilities.
Matches current assets that are or will become cash in the next
year with obligations that are due in the next year.
Quick Ratio = (Cash + Marketable Securities+ A/R) /
Current Liabilities.

Prof. Charles E. Wasley 3

Other Short-Term Liquidity Ratios

Operating Cash Flow (OCF) to Current Liabilities Ratio =

Operating Cash Flow / Average Current Liabilities.
An advantage of this ratio is it is based on cash flow AFTER funding
needs for working capital (i.e., A/R and inventory) have been
considered.
Average Current Liabilities is used in the denominator to be consistent with the
numerator (OCF is generated over the course of the year).
A ratio of 1.0 indicates a firm could pay (if it had to) all of its current
liabilities out of the cash it generates from operations (i.e., without any
external funding).

Operating Cash Flow to Total Liabilities Ratio = Operating

Cash Flow/Average Total Liabilities.
What are your interpretations of this ratio?
Prof. Charles E. Wasley 4
Capital Structure (Long-Term
Solvency) Ratios

Provide insight into the mix of debt and equity in a firms capital structure
(there are numerous other ratios in this category).

Long-term = Long-term Debt

Debt Ratio (Long-term Debt + Shareholders Equity)

Debt/Equity = Long-term Debt

Ratio Shareholders Equity

Total Liabilities/Assets = Total Liabilities

Ratio Total Assets

Prof. Charles E. Wasley 5

Earnings Interest Coverage
Ratio

Measures the safety of fixed interest payments due

bondholders and other providers of interest-bearing debt.

In particular, it measures how many times net income before

interest expense and income taxes exceeds interest expense.

= (Net Income + Interest Expense + Income Tax Expense) / Interest

Expense.
Interest expense is typically net of interest income.

= Earnings Before Interest and Taxes EBIT / Interest Expense.

What are your interpretations of this ratio?

Prof. Charles E. Wasley 6
Cash Flow Interest Coverage
Ratio

A criticism of the earnings interest coverage ratio is

it uses earnings rather than cash flow in the
numerator.
Obviously, firms pay interest and other fixed charges with
cash not earnings.

A coverage ratio using cash flows is:

Operating Cash Flow +

Cash Payments for Interest +
Cash Payments for Income Taxes
Cash Payments for Interest
Prof. Charles E. Wasley 7
Operating Cash Flow to Capital
Expenditure Ratio

Operating Cash Flow

Capital Expenditures

Assesses the ability of a firm to generate cash flow

from operations in excess of the capital expenditures
needed to maintain and build physical capacity.

The excess cash flow can be used to service debt,

pay dividends or repurchase common shares.
Prof. Charles E. Wasley 8
Performing Analysis of Liquidity and
Solvency

The attached pages contain select liquidity and capital

structure ratios for Wal-Mart and Target.

Identify some important aspects of the analysis.

The firms original financial statements appear in Appendix B.

Prof. Charles E. Wasley 9

Wal-Marts Liquidity and Capital
Structure Ratios
LIQUIDITY RATIOS 31-Jan-2014 31-Jan-2013 31-Jan-2012 31-Jan-2011 31-Jan-2010 31-Jan-2009 31-Jan-2008 31-Jan-2007 31-Jan-2006
CURRENT RATIO 0.88 0.83 0.88 0.89 0.86 0.88 0.82 0.90 0.90
QUICK RATIO 0.20 0.20 0.20 0.21 0.22 0.20 0.16 0.20 0.18
CASH RATIO 0.10 0.11 0.11 0.13 0.14 0.13 0.09 0.15 0.13
OCF TO CL RATIO 0.33 0.38 0.40 0.41 0.47 0.41 0.37 0.40 0.40

Solvency and COVERAGE RATIOS 31-Jan-2014 31-Jan-2013 31-Jan-2012 31-Jan-2011 31-Jan-2010 31-Jan-2009 31-Jan-2008 31-Jan-2007 31-Jan-2006
LTD / (LTD +SE) 36.9% 35.2% 39.8% 39.0% 34.1% 34.6% 34.1% 33.3% 36.1%
LTD / SE 58.4% 54.3% 66.0% 64.0% 51.7% 52.9% 51.7% 49.9% 56.6%
TOTAL LIABILITIES / TOTAL ASSETS 62.8% 62.4% 63.1% 62.1% 58.6% 60.1% 60.5% 59.4% 61.5%
TOTAL LIABILITIES / STOCK EQUITY 168.5% 166.0% 171.2% 163.8% 141.8% 150.3% 153.1% 146.2% 159.9%
SE / TOTAL ASSETS 37.2% 37.6% 36.9% 37.9% 41.4% 39.9% 39.5% 40.6% 38.5%
DEBT-TO-EQUITY RATIO 74.3% 70.9% 74.9% 72.7% 58.6% 64.7% 69.1% 63.4% 72.8%
NET DEBT-TO EQUITY RATIO 64.7% 60.7% 65.7% 62.0% 47.4% 53.5% 60.6% 50.8% 61.2%
DEBT-TO-CAPITAL RATIO 42.6% 41.5% 42.8% 42.1% 37.0% 39.3% 40.9% 38.8% 42.1%
NET DEBT-TO-NET CAPITAL RATIO 39.3% 37.8% 39.7% 38.3% 32.2% 34.9% 37.7% 33.7% 38.0%
OCF TO TL RATIO 18.2% 20.6% 20.7% 22.3% 26.5% 23.5% 21.9% 23.1% 23.4%

INTEREST COVERAGE (EARNINGS BASIS) 11.51 12.33 11.42 11.58 11.62 10.42 10.44 11.33 13.18
INTEREST COVERAGE (CASH BASIS) 14.50 15.54 13.85 15.16 16.71 17.64 17.61 18.32 18.41
COMMON SHARES REPURCHASES TO OCF 0.29 0.30 0.26 0.62 0.28 0.15 0.37 0.08 0.20
OCF TO CAPEX RATIO 1.77 1.98 1.80 1.86 2.15 2.01 1.38 1.29 1.26
Prof. Charles E. Wasley 10
 Targets Liquidity and Capital
Structure Ratios
LIQUIDITY RATIOS 01-Feb-2014 02-Feb-2013 28-Jan-2012 29-Jan-2011 30-Jan-2010 31-Jan-2009 02-Feb-2008 03-Feb-2007 28-Jan-2006
CURRENT RATIO 0.91 1.17 1.15 1.71 1.63 1.66 1.60 1.32 1.50
QUICK RATIO 0.05 0.06 0.47 0.78 0.81 0.85 0.89 0.63 0.76
CASH RATIO 0.05 0.05 0.04 0.06 0.05 0.05 0.05 0.07 0.17
OCF TO CL RATIO 0.49 0.38 0.45 0.49 0.54 0.40 0.36 0.47 0.50

Solvency and COVERAGE RATIOS 01-Feb-2014 02-Feb-2013 28-Jan-2012 29-Jan-2011 30-Jan-2010 31-Jan-2009 02-Feb-2008 03-Feb-2007 28-Jan-2006
LTD / (LTD +SE) 44.5% 47.3% 46.5% 50.2% 49.6% 56.1% 49.7% 35.7% 39.1%
LTD / SE 80.1% 89.6% 86.9% 100.8% 98.5% 127.6% 98.8% 55.5% 64.2%
TOTAL LIABILITIES / TOTAL ASSETS 64.2% 65.9% 66.2% 64.6% 65.5% 68.9% 65.6% 58.1% 59.4%
TOTAL LIABILITIES / STOCK EQUITY 179.7% 193.3% 195.4% 182.2% 190.2% 221.7% 191.1% 138.9% 146.4%
SE / TOTAL ASSETS 35.8% 34.1% 33.8% 35.4% 34.5% 31.1% 34.4% 41.9% 40.6%
DEBT-TO-EQUITY RATIO 87.4% 107.9% 110.9% 101.5% 109.6% 136.8% 111.6% 64.2% 69.5%
NET DEBT-TO EQUITY RATIO 83.0% 103.1% 105.9% 90.5% 95.2% 130.5% 95.6% 59.0% 57.9%
DEBT-TO-CAPITAL RATIO 46.6% 51.9% 52.6% 50.4% 52.3% 57.8% 52.8% 39.1% 41.0%
NET DEBT-TO-NET CAPITAL RATIO 45.4% 50.8% 51.4% 47.5% 48.8% 56.6% 48.9% 37.1% 36.7%
OCF TO TL RATIO 21.8% 17.1% 18.4% 18.4% 19.7% 14.9% 16.2% 22.9% 22.2%

INTEREST COVERAGE (EARNINGS BASIS) 5.56 7.05 6.12 6.91 5.81 4.92 7.89 8.49 8.20
INTEREST COVERAGE (CASH BASIS) 8.06 9.94 9.02 9.68 9.60 7.68 10.26 12.45 13.60
COMMON SHARES REPURCHASES TO OCF 0.22 0.35 0.34 0.47 0.07 0.64 0.60 0.19 0.27
OCF TO CAPEX RATIO 1.89 1.62 1.24 2.48 3.40 1.25 0.94 1.24 1.31
Prof. Charles E. Wasley 11
Financial Distress and the Risk of
Default

What financial statement variables/ratios do you

think will be associated with (i.e., correlated with
financial distress, the probability of defaulting on a
loan and/or bankruptcy?

Why?

Prof. Charles E. Wasley 12

Default Probabilities
The plots on the following slides portray ratios related to a firms default
probability (i.e., the probability it will default on a loan).

The distribution of each ratio is computed using all public firms over a 20-
year period (excluding banks, insurance firms and real estate firms
because their financial characteristics are so different from the majority of
firms).

For each ratio, the data are sorted into 10 equal-sized groups, called
deciles.

The graphs plot the frequency that firms in each decile defaulted over the
next five years.

Each figure also shows the cutoffs for each decile (just above the axis),
for example the line between decile 5 and 6 is the median value of the
ratio for the entire sample.

Interpret the information conveyed by the each plot.

Prof. Charles E. Wasley 13
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 Altmans Z-Score

A well-known financial distress prediction model is Altmans Z-score

(Altman used manufacturing firms to develop the model).

Z-score = 1.2(Working Capital/Total Assets) +

1.4(Retained Earnings/Total Assets) +
3.3(Earnings Before Interest and Taxes/Total Assets) +
0.6(Market Value of Equity/Book Value of Total liabilities) +
1.0(Sales/Total Assets).

Z-scores of less than 1.81 indicate a high probability of bankruptcy while Z-

scores higher than 3.00 indicate a low probability of bankruptcy.

Scores between 1.81 and 3.00 are a gray area (no prediction).

Prof. Charles E. Wasley 17

 Wal-Marts Z-Score (Thoughts)
Wal-Mart Stores, Inc.
FINANCIAL DISTRESS ANALYSIS:
FISCAL YEAR ENDED (MOST RECENT YEAR FIRST) 31-Jan-2014 31-Jan-2013 31-Jan-2012 31-Jan-2011 31-Jan-2010 31-Jan-2009 31-Jan-2008 31-Jan-2007 31-Jan-2006
ALTMAN'S Z-SCORE:
Z-SCORE = 1.2(NET WORKING CAPITAL/TOTAL ASSETS)
+ 1.4(RETAINED EARNINGS/TOTAL ASSETS) +
3.3(EBIT/TOTAL ASSETS) + 0.6(MARKET
VALUE OF EQUITY/BOOK VALUE OF LIABILITIES) +
1.0(SALES/TOTAL ASSETS)

INPUT: STOCK PRICE AT FISCAL YEAR END $78.69 $69.95 $61.36 $56.07 $53.43 $47.12 $50.74 $47.69 $46.11
INPUT: SHARES OUTSTANDING FISCAL YEAR END 3,235,772 3,345,238 3,424,697 3,561,994 3,810,172 3,922,552 4,004,809 4,168,025 4,163,490
MARKET VALUE OF EQUITY IN DOLLARS $254,622,899 $233,999,398 $210,139,408 $199,721,004 $203,577,490 $184,830,650 $203,204,009 $198,773,112 $191,978,524

ADJUST PRIOR LINE FOR MARKET VALUE OF EQUITY IN

DOLLARS TO MATCH FINANCIAL STATEMENT NUMBERS
ABOVE ($000s OR $000,000s, ETC) $254,623 $233,999 $210,139 $199,721 $203,577 $184,831 $203,204 $198,773 $191,979
NET WORKING CAPITAL/TOTAL ASSETS -0.040 -0.058 -0.038 -0.036 -0.044 -0.039 -0.064 -0.034 -0.036
RETAINED EARNINGS/TOTAL ASSETS 0.374 0.359 0.355 0.354 0.389 0.390 0.351 0.368 0.355
EBIT/TOTAL ASSETS 0.131 0.137 0.137 0.141 0.141 0.139 0.134 0.135 0.135

MARKET VALUE OF EQUITY/BOOK VALUE OF LIABILITIES 1.982 1.846 1.721 1.779 2.037 1.883 2.055 2.208 2.258
SALES/TOTAL ASSETS 2.326 2.307 2.309 2.333 2.395 2.474 2.306 2.298 2.259

Z-SCORE =============================> 4.424 4.298 4.245 4.319 4.574 4.561 4.396 4.544 4.514

Z-SCORES LESS THAN 1.81 INDICATE A HIGH

PROBABILITY OF BANKRUPTCY WHILE Z-SCORES
HIGHER THAN 3.00 INDICATE A LOW PROBABILITY OF
BANKRUPTCY. Z-SCORES BETWEEN 1.81 AND 3.00 ARE A
GRAY AREA (NO PREDICTION).

Prof. Charles E. Wasley 18

 Targets Z-Score (Thoughts)
Target Corporation
FINANCIAL DISTRESS ANALYSIS:
FISCAL YEAR ENDED (MOST RECENT YEAR FIRST) 01-Feb-2014 02-Feb-2013 28-Jan-2012 29-Jan-2011 30-Jan-2010 31-Jan-2009 02-Feb-2008 03-Feb-2007 28-Jan-2006
ALTMAN'S Z-SCORE:
Z-SCORE = 1.2(NET WORKING CAPITAL/TOTAL
ASSETS) + 1.4(RETAINED EARNINGS/TOTAL ASSETS) +
3.3(EBIT/TOTAL ASSETS) + 0.6(MARKET
VALUE OF EQUITY/BOOK VALUE OF LIABILITIES) +
1.0(SALES/TOTAL ASSETS)

INPUT: STOCK PRICE AT FISCAL YEAR END $63.27 $60.41 $50.81 $54.83 $51.27 $31.20 $55.42 $61.36 $54.75
INPUT: SHARES OUTSTANDING FISCAL YEAR END 632,088 650,794 671,597 708,082 752,313 752,780 830,845 858,887 879,184
MARKET VALUE OF EQUITY IN DOLLARS $39,992,208 $39,314,466 $34,123,844 $38,824,136 $38,571,088 $23,486,736 $46,045,430 $52,701,306 $48,135,324

ADJUST PRIOR LINE FOR MARKET VALUE OF EQUITY

IN DOLLARS TO MATCH FINANCIAL STATEMENT
NUMBERS ABOVE ($000s OR $000,000s, ETC) $39,992 $39,314 $34,124 $38,824 $38,571 $23,487 $46,045 $52,701 $48,135
NET WORKING CAPITAL/TOTAL ASSETS -0.027 0.049 0.046 0.163 0.159 0.158 0.160 0.096 0.138
RETAINED EARNINGS/TOTAL ASSETS 0.286 0.274 0.278 0.291 0.291 0.259 0.286 0.359 0.343
EBIT/TOTAL ASSETS 0.086 0.112 0.114 0.120 0.105 0.100 0.118 0.136 0.125
MARKET VALUE OF EQUITY/BOOK VALUE OF
LIABILITIES 1.412 1.244 1.108 1.376 1.322 0.773 1.574 2.427 2.315
SALES/TOTAL ASSETS 1.647 1.528 1.500 1.542 1.468 1.473 1.422 1.593 1.504

Z-SCORE =============================> 3.145 3.087 2.987 3.367 3.205 2.819 3.350 4.115 3.950

Z-SCORES LESS THAN 1.81 INDICATE A HIGH

PROBABILITY OF BANKRUPTCY WHILE Z-SCORES
HIGHER THAN 3.00 INDICATE A LOW PROBABILITY OF
BANKRUPTCY. Z-SCORES BETWEEN 1.81 AND 3.00 ARE
A GRAY AREA (NO PREDICTION).

Prof. Charles E. Wasley 19

A Multivariate Distress Prediction:
Logit Model Ohlsons Model

Logit analysis (a logistic regression model) is an alternative to Altmans Z-

Score.
A key feature of a Logit model is:
It provides an estimate of the probability of bankruptcy (which is much easier to
interpret when compared to a Z-score).

A logit model defines the probability of bankruptcy as:

p(bankruptcy) = 1 / (1 + e-y), (where e = 2.71)
The exponent y is a multivariate function that includes a constant and coefficients for
a set of explanatory variables (i.e., the financial statement ratios).

A Logit Model developed by Ohlson (1980) predicts the probability of

bankruptcy (y) one-year in advance as follows:
y = - 1.32 - 0.407(Size) + 6.03(TLTA) - 1.43(WCTA) + 0.0757(CLCA) -
2.37(NITA) - 1.83(FUTL) + 0.285(INTWO) - 1.72(OENEG) - 0.521(CHIN).

Prof. Charles E. Wasley 20

Ohlson Models Explanatory Variables

SIZE = Natural log of (Total Assets/GNP Implicit Price Deflator Index).

The price index is as of the end of the year prior to the year-end of the balance sheet date to allow for real-time
implementation of the model. To implement the model, the GNP Implicit Price Deflator must be scaled so that
December 1968 = 100.0.

TLTA = Total Liabilities / Total Assets.

WCTA = (Current Assets - Current Liabilities) / Total Assets.

CLCA = Current Liabilities / Current Assets.

NITA = Net Income / Total Assets.

FUTL = Working Capital from Operations / Total Liabilities.

Working capital from operations equals net income plus add-backs for expenses (such as depreciation) that do not
use cash.

INTWO = 1 if net income is negative for the last two years and 0 otherwise

OENEG = 1 if total liabilities exceed total assets and 0 otherwise.

CHIN = (Net Incomet - Net Incomet-1)

(|Net lncomet|+ |Net Incomet-1|).
Prof. Charles E. Wasley 21
Interpretation of the Coefficients

Variables with a positive coefficient increase the probability of bankruptcy

(they decrease e-y toward zero, which means that the bankruptcy probability
approaches 1/1 or 100%) while variables with a negative coefficient
decrease the probability of bankruptcy.

Consider the following examples illustrating the calculation of the

probability of bankruptcy for Wal-Mart and Target using fiscal 2013
numbers.
Wal-Mart: y = -5.987
p(bankruptcy) = 1 / (1+ e-(-5.987)) = 0.251%.
The probability of Wal-Mart going bankrupt is very small.

Target: y = -5.037
p(bankruptcy) = 1 / (1+ e-(-5.037)) = 0.645%.
The probability of Target going bankrupt is very small.

Prof. Charles E. Wasley 22

 Wal-Marts Ohlson Model (Thoughts)
Wal-Mart Stores, Inc.
FISCAL YEAR ENDED (MOST RECENT YEAR FIRST) 31-Jan-2014 31-Jan-2013 31-Jan-2012 31-Jan-2011 31-Jan-2010 31-Jan-2009 31-Jan-2008 31-Jan-2007 31-Jan-2006
OHLSON'S PROBABILITY OF BANKRUPTCY:

y = - 1.32 - 0.407(SIZE) + 6.03(TLTA) - 1.43(WCTA) +

0.0757(CLCA) - 2.37(NITA) - 1.83(FUTL) + 0.285(INTWO) -
1.72(OENEG) - 0.521(CHIN)

SIZE =TOTAL ASSETS / GNP IMPLICIT PRICE DEFLATOR 19.826 19.835 19.806 19.757 19.703 19.677 19.697 19.683 19.621

TL/TA = TOTAL LIABILITIES/TOTAL ASSETS 0.628 0.624 0.631 0.621 0.586 0.601 0.605 0.594 0.615

WCTA = (CURRENT ASSETS-CURRENT

LIABILITIES)/TOTAL ASSETS -0.040 -0.058 -0.038 -0.036 -0.044 -0.039 -0.064 -0.034 -0.036

CLCA = CURRENT LIABILITIES / CURRENT ASSETS 1.133 1.198 1.133 1.127 1.156 1.132 1.218 1.110 1.114

NITA = NET INCOME / TOTAL ASSETS 0.078 0.084 0.081 0.091 0.084 0.082 0.078 0.074 0.081

FUTL = WORKING CAPITAL FROM OPERATIONS / TOTAL

LIABILITIES 0.194 0.201 0.195 0.214 0.215 0.205 0.193 0.186 0.187

INTWO = 1 IF NET INCOME IS NEGATIVE THE LAST TWO

YEARS, 0 OTHERWISE. 0 0 0 0 0 0 0 0 0

OENEG = 1 OF STOCKHOLDERS' EQUITY IS NEGATIVE, 0

OTHERWISE. 0 0 0 0 0 0 0 0 0

CHIN = (NET INCOME THIS YEAR - NET INCOME LAST

YEAR) / ( |NET INCOME THIS YEAR| + |NET INCOME LAST
YEAR| ) -0.030 0.040 -0.022 0.066 0.036 0.025 0.060 0.002 0.045
SEE THE LECTURE NOTES FOR THE VARIABLE
DEFINITIONS

THE VALUE OF "y" IS: -5.987 -6.042 -5.973 -6.121 -6.265 -6.148 -6.074 -6.136 -6.018
OHLSON'S PROBABILITY OF BANKRUPTCY IS: 0.251% 0.237% 0.254% 0.219% 0.190% 0.213% 0.230% 0.216% 0.243%

Prof. Charles E. Wasley 23

 Targets Ohlson Model (Thoughts)
Target Corporation
FISCAL YEAR ENDED (MOST RECENT YEAR FIRST) 01-Feb-2014 02-Feb-2013 28-Jan-2012 29-Jan-2011 30-Jan-2010 31-Jan-2009 02-Feb-2008 03-Feb-2007 28-Jan-2006
OHLSON'S PROBABILITY OF BANKRUPTCY:

y = - 1.32 - 0.407(SIZE) + 6.03(TLTA) - 1.43(WCTA) +

0.0757(CLCA) - 2.37(NITA) - 1.83(FUTL) + 0.285(INTWO) -
1.72(OENEG) - 0.521(CHIN)

SIZE =TOTAL ASSETS / GNP IMPLICIT PRICE

DEFLATOR 18.291 18.391 18.382 18.337 18.362 18.368 18.397 18.282 18.248

TL/TA = TOTAL LIABILITIES/TOTAL ASSETS 0.642 0.659 0.662 0.646 0.655 0.689 0.656 0.581 0.594

WCTA = (CURRENT ASSETS-CURRENT

LIABILITIES)/TOTAL ASSETS -0.027 0.049 0.046 0.163 0.159 0.158 0.160 0.096 0.138

CLCA = CURRENT LIABILITIES / CURRENT ASSETS 1.104 0.856 0.869 0.585 0.615 0.601 0.623 0.756 0.666

NITA = NET INCOME / TOTAL ASSETS 0.045 0.063 0.063 0.067 0.056 0.050 0.064 0.075 0.069

FUTL = WORKING CAPITAL FROM OPERATIONS /

TOTAL LIABILITIES 0.148 0.163 0.164 0.177 0.155 0.133 0.154 0.197 0.184

INTWO = 1 IF NET INCOME IS NEGATIVE THE LAST

TWO YEARS, 0 OTHERWISE. 0 0 0 0 0 0 0 0 0

OENEG = 1 OF STOCKHOLDERS' EQUITY IS NEGATIVE,

0 OTHERWISE. 0 0 0 0 0 0 0 0 0

CHIN = (NET INCOME THIS YEAR - NET INCOME LAST

YEAR) / ( |NET INCOME THIS YEAR| + |NET INCOME
LAST YEAR| ) -0.207 0.012 0.002 0.080 0.058 -0.125 0.011 0.073 -0.141
SEE THE LECTURE NOTES FOR THE VARIABLE
DEFINITIONS

THE VALUE OF "y" IS: -5.037 -5.289 -5.264 -5.604 -5.468 -5.118 -5.470 -5.911 -5.737
OHLSON'S PROBABILITY OF BANKRUPTCY IS: 0.645% 0.502% 0.515% 0.367% 0.420% 0.595% 0.419% 0.270% 0.322%

Prof. Charles E. Wasley 24

Debt Ratings and Accounting
Numbers/Ratios

Debt ratings provide important information to

investors.

Debt ratings influence the yield that debt instruments

must pay to investors.

The following slides list:

1) Median financial statement numbers and ratios by debt
rating category.
2) Factors used in quantitative models of debt ratings by
various debt rating firms.

Professor Charles E. Wasley 25

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Managerial (Lender) Decision
Problem #1

Many lending agreements require borrowers to

obtain permission from the lender before
undertaking a major acquisition or asset sale.

Why would you as a lender want to include this

type of restriction in a lending agreement you are
negotiating?

Think about this question carefully before flipping to

the suggested answer on the following slide.
Prof. Charles E. Wasley 28
Managerial (Lender) Decision
Problem #1: Suggested Answer

When a firm starts to get into financial difficulty, conflicts of interest

begin to arise between debtors and stockholders.
For example, managers acting in the interests of stockholders may opt to
invest in riskier assets and projects.

Since the stock has an option value, a major acquisition of risky assets by
a firm in financial distress increases the value of stock, but decreases the
value of debt.

So to protect against the possibility of increased risk AFTER the lending

agreement is signed, some lenders include covenants requiring borrowers
to obtain permission before making a major acquisition.

Such covenants may also restrict asset sales because such sales can
serve to reduce the security (i.e., collateral) lenders have in event of
bankruptcy.
Prof. Charles E. Wasley 29
 Review Question #1

U.S. firms:
With low leverage have an interest-bearing net debt-to-equity ratios of 0% or
less.
With medium leverage have a ratio between 1% and 62%.
With high leverage have a ratio of 63% or more.

So how and why would you classify the following companies firms in terms
of their optimal debt-to-equity ratio (high, medium, or low)?
A successful pharmaceutical company.
An electric utility.
A manufacturer of consumer durables.
A commercial bank.
A start-up software company.

Think about this question carefully before flipping to the suggested answer
on the following slides. Prof. Charles E. Wasley 30
Review Question #1: Suggested
Response

A successful pharmaceutical company:

Low debt-to-equity ratio.
This firms business risks are relatively high and its assets can be easily
destroyed by financial distress.
The major assets of a pharmaceutical firm are human capital and R&D-related
intangibles.

An electric utility:
High debt-to-equity ratio.
Debt is a favorable form of financing for an electric utility because an
electric utility has low business risks.
An electric firms revenues and earnings are not sensitive to the
fluctuations in the economy.
In addition, an electric utility typically has large tangible assets to provide
security for lenders.
Prof. Charles E. Wasley 31
Review Question #1: Suggested
Response

A manufacturer of consumer durables:

Medium debt-to-equity ratio.
A manufacturer of consumer durables is faced with a medium level
competition.
Its main assets include equipment (tangible assets) and technology
(intangible assets), so the cost of financial distress is medium.
A commercial bank:
High debt-to-equity ratio.
Commercial banks have a high proportion of liquid assets.
Also, deposit insurance reduces depositors risk.

Prof. Charles E. Wasley 32

Review Question #1: Suggested
Response

A start-up software company.

Low debt-to-equity ratio.
A start-up firms business risks, similar to that of a pharmaceutical firm,
are relatively high and its assets can be easily destroyed by financial
distress.

Prof. Charles E. Wasley 33

Appendix A: Summary Statistics
for Various Financial Ratios

The following 3 slides contain the summary ratio statistics

(e.g., mean, median, standard deviation and lower and upper
quartile) for the ratios studied to in the lecture notes.

Prof. Charles E. Wasley 34

Prof. Charles E. Wasley 35
Prof. Charles E. Wasley 36
Prof. Charles E. Wasley 37
Appendix B: Wal-Marts and Targets
Actual Financial Statements

The firms actual income statements and balance sheets

appear on the following slides.

Professor Charles E. Wasley 38

Wal-Mart Stores, Inc.
FISCAL YEAR ENDED (MOST RECENT YEAR FIRST) 31-Jan-2014 31-Jan-2013 31-Jan-2012 31-Jan-2011 31-Jan-2010 31-Jan-2009 31-Jan-2008 31-Jan-2007 31-Jan-2006 31-Jan-2005
Net Sales $473,076 $465,604 $443,416 $418,952 $405,132 $401,087 $373,821 $344,759 $308,945 $281,488
Membership and other income $3,218 $3,047 $3,093 $2,897 $2,953 $3,167 $3,202 $3,609 $3,156 $2,822
TOTAL OPERATING REVENUES $476,294.0 $468,651.0 $446,509.0 $421,849.0 $408,085.0 $404,254.0 $377,023.0 $348,368.0 $312,101.0 $284,310.0
COST OF GOODS $358,069 $352,297 $334,993 $314,946 $304,106 $303,941 $284,137 $263,979 $237,649 $216,832
GROSS PROFIT $118,225.0 $116,354.0 $111,516.0 $106,903.0 $103,979.0 $100,313.0 $92,886.0 $84,389.0 $74,452.0 $67,478.0
SELLING, GENERAL & ADMINISTRATIVE EXPENSES $91,353 $88,629 $85,025 $81,361 $79,717 $77,546 $70,934 $63,892 $55,739 $50,178
RESTRUCTURING CHARGES $0.0 $0.0 $0.0 $0.0 $260.0 $0.0 $0.0 $0.0 $0.0 $0.0
TOTAL OPERATING EXPENSES $91,353.0 $88,629.0 $85,025.0 $81,361.0 $79,977.0 $77,546.0 $70,934.0 $63,892.0 $55,739.0 $50,178.0
INCOME BEFORE INTEREST AND TAXES $26,872.0 $27,725.0 $26,491.0 $25,542.0 $24,002.0 $22,767.0 $21,952.0 $20,497.0 $18,713.0 $17,300.0
INTEREST EXPENSE $2,335 $2,249 $2,320 $2,205 $2,065 $2,184 $2,103 $1,809 $1,420 $1,184
INTEREST INCOME $119 $186 $161 $201 $181 $284 $309 $280 $242 $204
INCOME BEFORE TAXES $24,656.0 $25,662.0 $24,332.0 $23,538.0 $22,118.0 $20,867.0 $20,158.0 $18,968.0 $17,535.0 $16,320.0
PROVISION FOR INCOME TAXES $8,105 $7,958 $7,924 $7,579 $7,156 $7,133 $6,889 $6,354 $5,803 $5,589
MINORITY INTEREST $673 $757 $688 $604 $513 $499 $406 $425 $324 $249
INCOME FROM CONTINUING OPERATIONS $15,878.0 $16,947.0 $15,720.0 $15,355.0 $14,449.0 $13,235.0 $12,863.0 $12,189.0 $11,408.0 $10,482.0
DISCONTINUED OPERATION (NET OF TAX) $144 $52 -$21 $1,034 -$79 $146 -$132 -$905 -$177 -$215
NET INCOME $16,022.0 $16,999.0 $15,699.0 $16,389.0 $14,370.0 $13,381.0 $12,731.0 $11,284.0 $11,231.0 $10,267.0
Prof. Charles E. Wasley 39
Wal-Mart Stores, Inc.
FISCAL YEAR ENDED (MOST RECENT YEAR FIRST) 31-Jan-2014 31-Jan-2013 31-Jan-2012 31-Jan-2011 31-Jan-2010 31-Jan-2009 31-Jan-2008 31-Jan-2007 31-Jan-2006 31-Jan-2005
CASH $7,281 $7,781 $6,550 $7,395 $7,907 $7,275 $5,492 $7,767 $6,193 $5,488
ACCOUNTS RECEIVABLE $6,677 $6,768 $5,937 $5,089.0 $4,144 $3,905 $3,642 $2,840 $2,575 $1,715
INVENTORIES $44,858 $43,803 $40,714 $36,437 $32,713 $34,511 $35,159 $33,685 $31,910 $29,762
Prepaid expenses and other $1,909 $1,588 $1,774 $2,960 $3,128 $3,063 $2,760 $2,690 $2,468 $1,889
Current assets of discontinued operation $460 $0 $0 $131 $140 $195 $967 $0 $679 $0
TOTAL CURRENT ASSETS $61,185.0 $59,940.0 $54,975.0 $52,012.0 $48,032.0 $48,949.0 $48,020.0 $46,982.0 $43,825.0 $38,854.0

PROP, PLANT & EQUIP (GROSS) $178,678 $171,724 $160,938 $154,489 $143,517 $131,161 $127,992 $115,190 $100,929 $88,593
ACCUMULATED DEP -$60,771 -$55,043 -$48,614 -$46,611 -$41,210 -$35,508 -$31,125 -$26,750 -$23,064 -$20,475
PROP, PLANT & EQUIP (NET) $117,907.0 $116,681.0 $112,324.0 $107,878.0 $102,307.0 $95,653.0 $96,867.0 $88,440.0 $77,865.0 $68,118.0
GOODWILL $19,510 $20,497 $20,651 $16,763 $16,126 $15,260 $15,879 $13,759 $12,097 $10,803
Other assets and deferred charges $6,149 $5,987 $5,456 $4,129 $3,942 $3,567 $2,748 $2,406 $4,400 $2,379
TOTAL LONG-TERM ASSETS $143,566.0 $143,165.0 $138,431.0 $128,770.0 $122,375.0 $114,480.0 $115,494.0 $104,605.0 $94,362.0 $81,300.0
TOTAL ASSETS $204,751.0 $203,105.0 $193,406.0 $180,782.0 $170,407.0 $163,429.0 $163,514.0 $151,587.0 $138,187.0 $120,154.0

FISCAL YEAR ENDED (MOST RECENT YEAR FIRST) 31-Jan-2014 31-Jan-2013 31-Jan-2012 31-Jan-2011 31-Jan-2010 31-Jan-2009 31-Jan-2008 31-Jan-2007 31-Jan-2006 31-Jan-2005
ACCOUNTS PAYABLE $37,415 $38,080 $36,608 $33,676 $30,451 $28,849 $30,344 $28,484 $25,101 $21,987
ACCRUED EXPENSES $18,793 $18,808 $18,180 $18,701 $18,734 $18,112 $15,725 $14,675 $13,274 $12,120
ACCRUED TAXES PAYABLE $966 $2,211 $1,164 $157 $1,347 $677 $1,000 $706 $1,340 $1,281
Current liabilities of discontinued oper $89 $0.0 $0.0 $47 $92 $83 $140 $0.0 $477 $0.0
SHORT-TERM DEBT $7,670 $6,805 $4,047 $1,031 $523 $1,506 $5,040 $2,570 $3,754 $3,812
CURRENT PORTION OF LTD $4,103 $5,587 $1,975 $4,655 $4,050 $5,848 $5,913 $5,428 $4,595 $3,759
CURRENT PORTION OF CAPITAL LEASES $309 $327 $326 $336 $346 $315 $316 $285 $284 $223
TOTAL CURRENT LIAB $69,345.0 $71,818.0 $62,300.0 $58,603.0 $55,543.0 $55,390.0 $58,478.0 $52,148.0 $48,825.0 $43,182.0

LONG TERM DEBT $41,771 $38,394 $44,070 $40,692 $33,231 $31,349 $29,799 $27,222 $26,429 $20,087
CAPITAL LEASE OBLIGATIONS $2,788 $3,023 $3,009 $3,150 $3,170 $3,200 $3,603 $3,513 $3,667 $3,171
Deferred income taxes and other $8,017 $7,613 $7,862 $6,682 $5,508 $6,014 $5,087 $4,971 $4,630 $2,978
Redeemable noncontrolling interest $1,491 $519 $404 $408 $307 $397 $0.0 $0.0 $0.0 $0.0
Nonredeemable noncontrolling interest $5,084 $5,395 $4,446 $2,705 $2,180 $1,794 $1,939 $2,160 $1,465 $1,340
TOTAL INTEREST BEARING LTL $44,559.0 $41,417.0 $47,079.0 $43,842.0 $36,401.0 $34,549.0 $33,402.0 $30,735.0 $30,096.0 $23,258.0
TOTAL NON-INTEREST BEARING LTL $14,592.0 $13,527.0 $12,712.0 $9,795.0 $7,995.0 $8,205.0 $7,026.0 $7,131.0 $6,095.0 $4,318.0
TOTAL LONG-TERM LIABILITIES $59,151.0 $54,944.0 $59,791.0 $53,637.0 $44,396.0 $42,754.0 $40,428.0 $37,866.0 $36,191.0 $27,576.0
TOTAL LIABILITIES $128,496.0 $126,762.0 $122,091.0 $112,240.0 $99,939.0 $98,144.0 $98,906.0 $90,014.0 $85,016.0 $70,758.0

COMMON STOCK $323 $332 $342 $352 $378 $393 $397 $413 $417 $423
PAID IN CAPITAL $2,362 $3,620 $3,692 $3,577 $3,803 $3,920 $3,028 $2,834 $2,596 $2,425
RETAINED EARNINGS $76,566 $72,978 $68,691 $63,967 $66,357 $63,660 $57,319 $55,818 $49,105 $43,854
ACCUMULATED COMPREHENSIVE INCOME (LOSS) -$2,996 -$587 -$1,410 $646 -$70 -$2,688 $3,864 $2,508 $1,053 $2,694
TOTAL SHAREHOLDER EQUITY $76,255.0 $76,343.0 $71,315.0 $68,542.0 $70,468.0 $65,285.0 $64,608.0 $61,573.0 $53,171.0 $49,396.0
TOTAL LIABILITIES & SHAREHOLDERS' EQUITY $204,751.0 $203,105.0 $193,406.0 $180,782.0 $170,407.0 $163,429.0 $163,514.0 $151,587.0 $138,187.0 $120,154.0

Prof. Charles E. Wasley 40

Target Corporation
FISCAL YEAR ENDED (MOST RECENT YEAR FIRST) 01-Feb-2014 02-Feb-2013 28-Jan-2012 29-Jan-2011 30-Jan-2010 31-Jan-2009 02-Feb-2008 03-Feb-2007 28-Jan-2006 29-Jan-2005
Sales $72,596 $71,960 $68,466 $65,786 $63,435 $62,884 $61,471 $57,878 $51,271 $45,682
Credit card revenues $0 $1,341 $1,399 $1,604 $1,922 $2,064 $1,896 $1,612 $1,349 $1,157
TOTAL OPERATING REVENUES $72,596.0 $73,301.0 $69,865.0 $67,390.0 $65,357.0 $64,948.0 $63,367.0 $59,490.0 $52,620.0 $46,839.0
COST OF GOODS $51,160 $50,568 $47,860 $45,725 $44,062 $44,157 $42,929 $40,366 $34,927 $31,445
GROSS PROFIT $21,436.0 $22,733.0 $22,005.0 $21,665.0 $21,295.0 $20,791.0 $20,438.0 $19,124.0 $17,693.0 $15,394.0
SELLING, GENERAL & ADMINISTRATIVE EXPENSES $15,375 $14,914 $14,106 $13,469 $13,078 $12,954 $12,670 $11,852 $11,185 $9,797
DEPRECIATION & AMORTIZATION EXPENSE $2,223 $2,142 $2,131 $2,084 $2,023 $1,826 $1,659 $1,496 $1,409 $1,259
Credit card expenses $0 $467 $446 $860 $1,521 $1,609 $837 $707 $776 $737
Gain on receivables transaction -$391 -$161 $0 $0 $0 $0 $0 $0 $0 $0
G/L on early Exting. of lease relat debt $445 $0 $0 $0 $0 $0 $0 $0 $0 $0
TOTAL OPERATING EXPENSES $17,652.0 $17,362.0 $16,683.0 $16,413.0 $16,622.0 $16,389.0 $15,166.0 $14,055.0 $13,328.0 $11,793.0
INCOME BEFORE INTEREST AND TAXES $3,784.0 $5,371.0 $5,322.0 $5,252.0 $4,673.0 $4,402.0 $5,272.0 $5,069.0 $4,365.0 $3,601.0
INTEREST EXPENSE $681 $762 $869.0 $760.0 $804.0 $894.0 $668.0 $597.0 $532.0 $589.0
INTEREST INCOME $0 $0 $3 $3 $3 $28 $21 $25 $27 $19
INCOME BEFORE TAXES $3,103.0 $4,609.0 $4,456.0 $4,495.0 $3,872.0 $3,536.0 $4,625.0 $4,497.0 $3,860.0 $3,031.0
PROVISION FOR INCOME TAXES $1,132 $1,610 $1,527 $1,575 $1,384 $1,322 $1,776 $1,710 $1,452 $1,146
INCOME FROM CONTINUING OPERATIONS $1,971.0 $2,999.0 $2,929.0 $2,920.0 $2,488.0 $2,214.0 $2,849.0 $2,787.0 $2,408.0 $1,885.0
DISCONTINUED OPERATION (NET OF TAX) $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $1,313.0
NET INCOME $1,971.0 $2,999.0 $2,929.0 $2,920.0 $2,488.0 $2,214.0 $2,849.0 $2,787.0 $2,408.0 $3,198.0
Prof. Charles E. Wasley 41
Target Corporation
FISCAL YEAR ENDED (MOST RECENT YEAR FIRST) 01-Feb-2014 02-Feb-2013 28-Jan-2012 29-Jan-2011 30-Jan-2010 31-Jan-2009 02-Feb-2008 03-Feb-2007 28-Jan-2006 29-Jan-2005
CASH $692 $654 $600 $583 $583 $562 $599 $813 $1,648 $2,245
SHORT-TERM INVESTMENTS $3 $130 $194 $1,129 $1,617 $302 $1,851 $0 $0 $0
ACCOUNTS RECEIVABLE $0 $0 $5,927 $6,153 $6,966 $8,084 $8,054 $6,194 $5,666 $5,069
INVENTORIES $8,766 $7,903 $7,918 $7,596 $7,179 $6,705 $6,780 $6,254 $5,838 $5,384
PREPAID ASSETS $0 $0 $0 $0 $0 $0 $0 $0 $0 $0
DEFERRED INCOME TAXES $177 $193 $275 $379 $724 $693 $556 $427 $344 $344
Credit card receivables, held for sale $0 $5,841 $0 $0 $0 $0 $0 $0 $0 $0
Vendor income receivable $555 $621 $592 $517 $390 $236 $244 $285 $560 $428
Other Receivables $0 $395 $411 $405 $526 $433 $353 $278 $0 $0
OTHER CURRENT ASSETS $1,380 $651 $532 $451 $439 $473 $469 $455 $349 $452
TOTAL CURRENT ASSETS $11,573.0 $16,388.0 $16,449.0 $17,213.0 $18,424.0 $17,488.0 $18,906.0 $14,706.0 $14,405.0 $13,922.0

PROP, PLANT & EQUIP (GROSS) $45,780 $43,964 $41,531 $37,048 $35,765 $34,816 $31,982 $28,381 $25,214 $22,272
ACCUMULATED DEP $14,402 $13,311 $12,382 $11,555 $10,485 $9,060 $7,887 $6,950 $6,176 $5,412
PROP, PLANT & EQUIP (NET) $31,378.0 $30,653.0 $29,149.0 $25,493.0 $25,280.0 $25,756.0 $24,095.0 $21,431.0 $19,038.0 $16,860.0
Company-owned life insurance investments $305 $269 $371 $358 $319 $305 $578 $559 $524 $446
GOODWILL $151 $59 $59 $59 $59 $60 $60 $60.0 $60.0 $206.0
INTANGIBLE ASSETS $206 $165 $183 $164 $180 $171 $148 $152 $123 $0.0
Interest Rate Swaps $62 $85 $114 $139 $131 $163 $215 $23 $0 $0
Prepaid Pension Expense $0 $0 $0 $0 $0 $1 $394 $325 $752 $733
OTHER LONG-TERM ASSETS $409 $338 $249 $279 $140 $162 $164 $93 $93 $126
TOTAL LONG-TERM ASSETS $32,511.0 $31,569.0 $30,125.0 $26,492.0 $26,109.0 $26,618.0 $25,654.0 $22,643.0 $20,590.0 $18,371.0
TOTAL ASSETS $44,084.0 $47,957.0 $46,574.0 $43,705.0 $44,533.0 $44,106.0 $44,560.0 $37,349.0 $34,995.0 $32,293.0

FISCAL YEAR ENDED (MOST RECENT YEAR FIRST) 01-Feb-2014 02-Feb-2013 28-Jan-2012 29-Jan-2011 30-Jan-2010 31-Jan-2009 02-Feb-2008 03-Feb-2007 28-Jan-2006 29-Jan-2005
ACCOUNTS PAYABLE $7,683 $6,468 $6,282 $6,067 $6,511 $6,337 $6,721 $6,575 $6,268 $5,779
ACCRUED EXPENSES $2,835 $3,471 $3,184 $3,039 $2,477 $2,282 $2,337 $2,195 $2,193 $1,633
ACCRUED TAXES PAYABLE $221 $272 $257 $144 $24 $0 $111 $422 $374 $304
Gift Card Liability $521 $503 $467 $422 $387 $381 $372 $338 $0 $0
Interest Payable $85 $91 $109 $103 $105 $130 $162 $122 $0 $0
Dividends Payable $272 $232 $202 $176 $127 $120 $115 $103 $0 $0
CURRENT PORTION OF LTD $1,160 $2,994 $3,786 $119 $1,696 $1,262 $1,964 $1,362 $753 $504
TOTAL CURRENT LIAB $12,777.0 $14,031.0 $14,287.0 $10,070.0 $11,327.0 $10,512.0 $11,782.0 $11,117.0 $9,588.0 $8,220.0

LONG TERM DEBT $12,622 $14,654 $13,697 $15,607 $15,118 $17,490 $15,126 $8,675 $9,119 $9,034
DEFERRED TAXES $1,433 $1,311 $1,191 $934 $835 $455 $470 $577 $851 $973
Other noncurrent liabilities $1,375 $1,439 $1,409 $1,479 $1,728 $1,619 $1,733 $1,347 $1,232 $1,037
Pension and postretirement health care $115 $170 $225 $128 $178 $318 $142 $0 $0 $0
TOTAL INTEREST BEARING LTL $12,622.0 $14,654.0 $13,697.0 $15,607.0 $15,118.0 $17,490.0 $15,126.0 $8,675.0 $9,119.0 $9,034.0
TOTAL NON-INTEREST BEARING LTL $2,923.0 $2,920.0 $2,825.0 $2,541.0 $2,741.0 $2,392.0 $2,345.0 $1,924.0 $2,083.0 $2,010.0
TOTAL LONG-TERM LIABILITIES $15,545.0 $17,574.0 $16,522.0 $18,148.0 $17,859.0 $19,882.0 $17,471.0 $10,599.0 $11,202.0 $11,044.0
TOTAL LIABILITIES $28,322.0 $31,605.0 $30,809.0 $28,218.0 $29,186.0 $30,394.0 $29,253.0 $21,716.0 $20,790.0 $19,264.0

COMMON STOCK $53 $54 $56 $59 $62 $63 $68 $72 $73 $74
PAID IN CAPITAL $4,470 $3,925 $3,487 $3,311 $2,919 $2,762 $2,656 $2,387 $2,121 $1,810
RETAINED EARNINGS $12,599 $13,155 $12,959 $12,698 $12,947 $11,443 $12,761 $13,417 $12,013 $11,148
ACCUMULATED COMPREHENSIVE INCOME (LOSS) -$1,360.0 -$782.0 -$737.0 -$581.0 -$581.0 -$556.0 -$178.0 -$243.0 -$2.0 -$3.0
TOTAL SHAREHOLDER EQUITY $15,762.0 $16,352.0 $15,765.0 $15,487.0 $15,347.0 $13,712.0 $15,307.0 $15,633.0 $14,205.0 $13,029.0
TOTAL LIABILITIES & SHAREHOLDERS' EQUITY $44,084.0 $47,957.0 $46,574.0 $43,705.0 $44,533.0 $44,106.0 $44,560.0 $37,349.0 $34,995.0 $32,293.0

Prof. Charles E. Wasley 42