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Level I CFA: Financial Statement Analysis: Applications-Lecture 1 - YouTube
Channel: IFT
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financial statement analysis
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applications in this reading we will
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talk about the
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application of financial statement
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analysis
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we will understand how to evaluate past
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financial performance we will then look
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at how to project
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future financial performance and then
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we will get into the two major reasons
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why analysts evaluate financial
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statements
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one is to assess credit risk and the
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other
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is related to equity investments
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and finally we will talk about
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adjustments to reported
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financials evaluating past
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financial performance these points are
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taken straight
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from the curriculum and they highlight
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what we need to consider
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when we evaluate past financial
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performance
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i will simply read this for you
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as an analyst you need to consider how a
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company's
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measures of profitability efficiency
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liquidity and solvency
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change over the period being analyzed
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and why is this happening as the
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industry matures
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a company might try to improve its
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efficiency
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if you are a credit analyst you might be
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particularly concerned with the
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liquidity and
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solvency of a company these are items
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that we will see in more detail later
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how do the level and trend in a
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company's
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profitability efficiency liquidity
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and solvency compare with the
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corresponding results
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of other companies in the same industry
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or more specifically you can look at the
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peer group
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and then how can the differences be
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explained
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what aspects of performance are critical
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for a company to successfully compete
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in its industry how did the company
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perform relative to those
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critical performance aspects and then
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what is the company's business strategy
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what is the company's business model
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and do the financials reflect the
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strategy
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the curriculum gives several examples in
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this
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reading most of the examples are fairly
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long-winded
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you can read the examples if they have
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time i think they are
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very interesting but from a testability
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perspective they are just a few core
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points
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that you need to recognize and what i'll
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try to do
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in this lecture is highlight those
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important points
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the first example is a case study on
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apple and it showcases how apple's
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change in strategy is reflected in its
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financial
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performance in the early to
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mid 2000s apple
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primarily was a personal
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computer company its sales
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came mostly from the apple macintosh or
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the mac
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but then apple changed its strategy
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and the focus moved away from being
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purely a pc company
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to a company that provides several
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integrated
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products and if you look at apple
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in 2010 it had
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the iphone apple sold
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ipads ipods music was downloadable
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through
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itunes so the product mix
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changed substantially and if we look at
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apple's
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revenue and the mix of revenue coming
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from different sources
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we will see that that product mix and
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the corresponding revenue changed
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substantially between 2007 and 2010
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so what that tells us is that the
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financial
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performance is reflecting apple's stated
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strategy apple strategy involved
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selling differentiated products so apple
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is a major innovator in its field
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and when a company sells differentiated
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products it can charge
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higher prices which is what apple does
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and that should be reflected in higher
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gross
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margins if you look at apple's gross
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margins between 2007
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and 2010 as the strategy was being
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implemented
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the gross margins are actually becoming
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better so that again reflects the fact
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that the financial numbers
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do point out that the strategy was
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working the impact on operating profit
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margins
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is weaker the reason is that for a
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company that is providing differentiated
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products
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innovative products there still needs to
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be a substantial amount of investment in
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r d
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in marketing and so on these
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relatively high costs will have a
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impact on profit margins so just because
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the company has differentiated products
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and higher gross margins
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doesn't necessarily mean that the
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operating profit margins will also be
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very high
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the example also showcases apple's
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liquidity
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if we look at the liquidity ratios they
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are quite high
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in the two to three range
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this says that apple had a lot of extra
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cash
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or at least a lot of current assets
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relative to
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liabilities there are several reasons
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why this might happen
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and there are several ways in which a
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company can use that extra cash
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one interpretation might be that this
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would be a
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inefficient usage of funds but another
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explanation would be that this
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is like apple's war chest where the
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extra liquidity could be used to make
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acquisitions
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example two highlights the effect of
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differences in accounting standards on
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return on equity comparisons return on
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equity is
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net income over equity we
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are looking at three telecom companies
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one is
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verizon in the u.s which uses u.s
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gaap then we have a telecom company in
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mexico using mexican gap
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and a company in brazil using brazilian
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gaap it is a long example but
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the main point is that differences in
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accounting standards can have a
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substantial impact
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on financial ratios in other words it
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does not make sense to
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take the unadjusted numbers
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for say return on equity and simply
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compare them
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if we do want to compare these three
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telecom companies which are using
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different accounting standards
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we need to first make sure that all the
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numbers are presented in a particular
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standard
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u.s gaap for example and then it makes
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more sense to compare ratios
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this example shows that after we make
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adjustments
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the change in ratios are quite
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significant
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next we talk about projecting future
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financial
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performance the first thing we need to
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do
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is forecast sales for a company
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and what is presented here is a
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simplistic way of forecasting
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sales we first forecast the expected gdp
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growth
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then we forecast the expected industry
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sales
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based on historical relationship with
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gdp so if historical data tells us that
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a three percent
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increase in gdp corresponds to a three
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percent increase
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in sales then we use that in some
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industries
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a three percent increase in gdp might
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have a much higher
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increase in sales numbers this
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relationship between increase in gdp
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and the company sales or the industry
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sales
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is available by looking at historical
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data and doing
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regression analysis we should then
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consider the market share of the company
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that we are evaluating
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and whether that market share is going
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to
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change or not if the market share is not
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going to change
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then we can simply say that the increase
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in sales will correspond to the
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increase in the size of the industry
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based on this information we then
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forecast company
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sales
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then to come up with the estimated net
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income we have to forecast
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expenses we can use
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historical margins such as gross profit
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margin
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and operating margins for stable
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companies
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and this works for companies such as jnj
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which are large and diversified
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and stable for companies
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which are not stable they might be new
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companies a company like facebook for
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example
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here we need to estimate each expense
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item we should also remove any
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non-recurring items
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because with our forecast we are
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concerned about revenue items and
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expense items that will recur
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those that will not recur should not be
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considered in our forecasts
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generally we estimate interest expense
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and tax expense
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separately the reason is with interest
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expense the amount depends
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on the level of debt and the
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rate so we have to estimate the debt
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that we expect in the future and we need
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to estimate the interest rate
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and it is the combination of these two
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which will define
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interest expense with tax expense
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we need to have an estimate for the tax
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rate
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and obviously the earnings before tax
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which will be
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calculated based on the forecasted sales
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and the forecasted expenses
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once we have the ebt and the tax rate we
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can come up with the
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tax expense
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to come up with cash flows we also need
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to estimate changes
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in working capital if our working
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capital such as
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inventory is going up that is not
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reflected
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in the income statement but obviously it
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has a
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impact on cash flow so an estimate of
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changes in working capital is important
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we should also estimate investment
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expenditures
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because these will not be reflected in
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the
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income statement but they also impact
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cash flow we need to estimate dividend
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payments
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and so on again these are just high
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level points
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with this information we can then
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project the
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cash flow for a given company
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the level of analysis presented here is
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simplistic
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but from a exam perspective this should
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be
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reasonable
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the curriculum presents several examples
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examples 2 3 and 4 are fairly long
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if you have time you can read them but
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what i'll do here is give you the most
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important
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point related to each example example
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two
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deals with using historical operating
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profit margin to forecast
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operating profits we are given the
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example of a stable diversified firm
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like jnj
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for a company like gnj it makes sense to
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use historical margins
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to project future operating profits
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whereas we are given another company
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which is
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a chinese search engine company that is
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relatively new
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there it would not make sense to use
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historical operating profit margins
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because of
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the uncertainties involved there it
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would make more sense
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to project each expense item
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separately example three deals with
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issues in
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forecasting the most important point in
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this example is
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that we need to recognize which expenses
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and which items are non-recurring
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so these items are not included in a
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forecasting model
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example four is a basic
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financial model or a basic financial
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forecast this
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is a spreadsheet model and i don't think
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this is overly testable
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the example here is based on the
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discussion from the previous slide
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so if you know all the items from the
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previous slide you are reasonably
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well prepared from a exam perspective
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example 5 is a multiple choice question
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it tests your knowledge of ratios i
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would strongly encourage you to
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do this example from the curriculum
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assessing credit risk imagine
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you are considering the purchase of a
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bond that has been issued by a company
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one of your major concerns will be
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whether the company will make its coupon
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payments and whether the company will
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make
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its principal payment at the end
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the process whereby you assess whether
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or not the company will make
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its payments is called assessing
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credit risk you can also call this
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credit
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analysis the high level items that you
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will be concerned with are the ability
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of the issuer to meet
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interest and principal payments on
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schedule to do this
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one of the most important things you
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will look at is
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cash flow forecasts this will look at
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the amount of cash flows and also the
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variability of cash flows if the cash
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flow
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is very volatile then obviously that
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will be a concern because if the cash
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flow is low
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then there will be a question as to
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whether coupon payments
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will be made you also need to consider
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the business risk and the financial risk
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of a company
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when we say business risk what we are
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talking about is the risk of the company
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not having sufficient revenues or the
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risk of
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expenses being too high financial risk
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arises
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when the level of debt is high which
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means that
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interest payments are high if the
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operating profits are low
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and debt is high then the company is in
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a very risky situation because
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all the operating income might get used
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in paying
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interest the curriculum gives
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some specific examples on assessing
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credit risk
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and i will again highlight the most
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important points
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you need to look at the size and scale
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of the company that has
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issued the bond or issued debt you need
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to look at total revenue
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you need to look at operating profit
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you need to look at the business profile
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revenue sustainability and efficiency
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if a company has relatively high revenue
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which is
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sustainable and the company is operating
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efficiently
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all these are indicators that the credit
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risk is good
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good credit risk means that the company
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will make
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its payments on time you should also
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consider financial leverage and
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flexibility
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with leverage ratios we are talking
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about ratios such as
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debt to equity low ratios are good
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because for a given amount of equity
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if a company has low debt that means
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that it will easily be able to make its
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debt related payments coverage ratios
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such as
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ebit over interest you want these
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ratios to be high high ratio means that
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the operating profit
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is relatively high compared to the
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interest payments
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debt over ebitda you want debt
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to be relatively low and ebitda
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which is a proxy for cash flows should
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ideally be high
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if this ratio is low that's a good thing
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free cash flow to debt you want free
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cash flow to be relatively high
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and debt to be relatively low so if this
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ratio is high
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that is good by good we mean
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low credit risk we should also be
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concerned about the liquidity of a
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company
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the classic liquidity ratio is the
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current ratio which is current assets
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over current liabilities
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if this ratio is high that means the
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company will easily
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meet its short-term obligations
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