Annual Report Financial Analysis – Part 3 Credit Risk

08 Aug 2015 14:36
Tags annual_report credit financial_statements

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Welcome to Part 3 of our Annual Report Financial Analysis. At the end of this series I will share the spreadsheet used throughout the exercise which will include all of the formulas to calculate the ratios and on which statement to find the values to populate.

As a reminder, to perform this exercise you will need the financial statements from your selected stock and one of its top competitors. Throughout this series we will be comparing Johnson & Johnson (JNJ) to Pfizer (PFE) as our example.

The benefit of performing a credit risk analysis will determine how much a creditor can claim if a company declares bankruptcy. An additional benefit of a credit analysis will yield how well a company is managing debt which will allow them to negotiate for better loan debt rates. This is no different than your personal credit scores, if you have a high FICO score you can get a low yield loan but if you have a low FICO you will get a high yield loan.
Total Assets and Liabilities can be found on the Balance Sheet Statement

Debt Ratio – A measure of how much assets can be liquidated to recover investments. This is not a liquidity measure but a measure of a creditor’s long term risk. The smaller amount of assets financed the less the risk. Companies with a low risk ratio will score at or below 1. Most financially sound companies will have debt ratios of 0.5 or lower. The debt ratio is calculated by dividing Total Liabilities by Total Assets.

Debt Ratio = Total Liabilities / Total Assets

Interest Coverage Ratio – A measure that determines how large (or small) of a margin that income can cover interest payments. Strong companies will have a ratio that exceeds 4.

Interest Coverage Ratio = Income Before Interest & Taxes / Annual Interest Expense

Net Cash Provided by Operating Activities Trend – A measure that trends a company’s ability to generate cash over time.

Net Cash Provided by Operating Activities Trend = (Current Net Cash Provided by Operating Activities - First Year Net Cash Provided by Operating Activities) / Net Cash Provided by Operating Activities + 1

Now we can try putting these to use by comparing Johnson & Johnson (JNJ) to Pfizer (PFE)

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Which company had overall better credit numbers? Both Johnson & Johnson (JNJ) and Pfizer (PFE) have strong Debt Ratios and Interest Coverage Ratios. But JNJ's strong and steady growth of increasing cash flow from year to year gives them a clear advantage.

In this round JNJ is the winner.

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