Cash analysis plays an essential role in financial analysis. As the change in cash flow is the result of all cash flows, its deterioration is a symptom of a malfunction which should be diagnosed. In addition, a continuous deterioration in cash will sooner or later result in the cessation of payments, the credit analyst trying to anticipate the occurrence by its analysis.
Let’s see how to ensure that the balance sheet reflects the true cash position, and what to do in the event of an abnormally high rate.
How to ensure that the balance sheet reflects the true cash position?
The apparent debt ratio is a cash ratio, it is equal to the financial costs divided by all the financial debts: loans from credit institutions, the financial market, shareholders or associates.
Financial charges = Apparent debt ratio
All financial debts
If the company borrows an approximately equivalent amount throughout the year, this rate indicates the average cost of its debt. An “abnormally high” rate is a sign that should alert the analyst. It indicates that the debt on the balance sheet at the end of the year is not consistent with the amount of financial expenses for the entire period. Most often, in practice, it is that short-term borrowing is lacking. An abnormally high rate has three main causes:
- The company is financed by credit for mobilization of customer receivables (factoring, Dally law, etc.). Under French standards, the financed customer receivable leaves the balance sheet because it is sold and the credit does not appear in the liabilities. However, the financial costs are recorded as expenses.
- The company artificially improves its cash position at the close to present a more favorable balance sheet. Concretely, the CFO offers an attractive discount rate to anticipate the payment of large customer invoices before the end of the year. It thus improves for a few days the cash position to take a more favorable picture of the balance sheet. The apparent rate will reveal the maneuver.
- Due to its seasonal activity, the company experiences large variations in its inventory and receivables. Often, these companies close their accounts when their working capital requirements are at their lowest. The cash position is therefore more favorable than it is on average over the year. However, financial costs reflect debt throughout the year. Example: a clothing distribution chain closes its accounts at the end of February, after the end of the sales period.
What is an abnormally high rate?
This is a significantly higher rate than the rate at which a company in this risk category borrows. Reference should be made to the rates for the period. Eonia and Euribor are the CT rate references, also applicable to variable rate MLT loans. The “probable” margin on financing should be added. Thus, for a Euribor rate of 4% and a margin on CT financing of 2%, the “normal” rate is around 6%. For a fixed rate MLT loan, the rates are higher. This ratio is not a fine measure; it allows significant differences to be detected. Thus, for an estimated borrowing rate of 6%, the debt situation can be considered normal if the apparent rate is between 5 and 8%.
What to do in the event of an abnormally high rate?
When the apparent rate is abnormally high, the analyst tries to estimate the real need for cash from finance costs.
For a financial cost of 500 and an estimated borrowing rate of 5%, the real debt situation would be:
500 = 10,000
If the apparent financial debt on the balance sheet is 8,000, the analyst will then add 2,000 to credits to CT as well as to customer receivables in the event of factoring.
This reprocessing is less relevant for companies with high seasonality because in this case, it is the current cash flow requirement which fluctuates during the year.