Read the following Question answers and give response:

1. Why is the evaluation of asset composition useful for capital structure analysis?

When analyzing capital structure it is important to understand both debt and equity. When looking at debt and equity we need to know what it is we are financing with the debt and equity. This is where assets come in. We need to know what categories and what types of assets exist within a company. Normally when looking at an asset composition it is broken down into a common size statement. It is good to know what percentage of a company’s assets are current versus which are long term. This will allow us to easily compare the assets to the liabilities both current and long term.

2. Is net income a reliable measure of cash available to meet fixed charges?

Net income is not the most reliable measure to determine if enough cash is on hand to meet fixed charges. This is because net income includes items that do not necessary translate to the cash basis nature of fixed charges. To determine the amount of cash to meet fixed charges we need to find pretax cash from operations. We do this by starting with pretax income and make adjustments based on whether or not they have been paid in cash. Net income includes items like depreciation and amortization that are not paid in cash and need to be added back to pretax income. In addition to this we would need to adjust for changes in current assets and current liabilities. From this we would get net cash flow from operating activities. This is a very good measure of a company’s ability to meet fixed charges. However to find the fixed charge ratio of a company a few more adjustments are needed. Finally we add back various interest expenses. This number is then compared to total fixed expenses to give us the fixed charge ratio.

3. Can an analysis of financial statements improve on published bond ratings? Explain.

Yes the analysis of financial statement can improve on published bond ratings. When it comes to making investing choices having the most information possible will always give the best results. When two bonds are rated the same it would be best to look to the financial statements to make a determination. There could be differences in the companies that would make one bond better than the other. The bond ratings are determined by companies with their own preferences in mind as well. Not all information is considered in the published bond ratings. It should also be noted that bond ratings lag behind the market. With careful analysis of financial statements, we could effectively determine the change before the published ratings changed.