Cash analysis is an essential part of the financial analysis. As cash flow is the result of all flows, its degradation is a symptom of a malfunction that needs to be diagnosed. In addition, a continuous deterioration of the cash flow will eventually result in the cessation of payments that the credit analyst tries 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 if the rate is abnormally high.
Ensure Balance Sheet Reflects the true Cash Position
The apparent rate of indebtedness is a cash ratio; it is equal to the financial expenses divided by all financial debts: loans from credit institutions, the financial market, shareholders or associates.
Financial expenses = Apparent debt = Ratio Total financial debt
If the company borrows roughly the same 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 end-of-year balance sheet debt is not consistent with the amount of financial expenses for the entire period. In most cases, in practice, short-term loans are lacking. An abnormally high rate has three main causes:
- The company is financed by credit of mobilization of receivables, (factoring, law Dally,). Under French GAAP, the financed customer receivable comes out of the balance sheet because it is sold and credit does not appear on the liabilities side. On the other hand, financial expenses are recorded as expenses.
- The company artificially improves its cash position at closing to present a more favorable balance sheet. In concrete terms, the CFO offers an attractive discount rate to anticipate the payment of large amounts of customer invoices before the end of the year. It thus improves for a few days the position of cash to take a more favorable picture of the balance sheet. The apparent rate will reveal the maneuver.
- Because of its seasonal activity, the company experiences large variations in its stock and its trade receivables. Often, these companies close their accounts while their need for working capital is at their lowest. The cash position is then more favorable than it is on average over the year. On the other hand, the financial expenses reflect the indebtedness 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 significantly higher than the rate at which a company in this risk category borrows. It is advisable to refer to the rates of the period. Ionia and Euribor are the reference rates to CT, also applicable to MLT floating rate loans. It is necessary to add the margin “probable” on financing. 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 can detect significant differences. Thus, for an estimated borrowing rate of 6%, the debt situation can be estimated normal if the apparent rate is between 5 and 8%.
What to do in Case of Abnormally High Rate?
When the apparent rate is abnormally high, the analyst seeks to estimate the true need for cash from financial expenses.
For a financial expense of 500 and an estimated borrowing rate of 5%, the actual debt situation would then be: 500 = 10 000 = 5%
If the apparent financial debt in the balance sheet is 8 000, the analyst will then add 2,000 credits to CT as well as to the accounts receivable in case of factoring. This reprocessing is less relevant for companies with a strong seasonality because in this case, it is the need for real cash itself that fluctuates during the year.