Predicting a Firms Financial Distress
Predicting a Firm’s Financial Distress: The Merrill Lynch Co.
Richard Hamilton
Mike Rakes
Brandon Sather
Teresa Sexton
Narrative:
Merrill Lynch is financing the business through Cash provided by financing activities – the operating activities loss is offset by increases in long-term borrowings.
1. Evaluate the cash position at year-end
Report Date 12/28/2007 12/29/2006 12/30/2005
Cash & cash equivalents 41,346,000 32,109,000 14,586,000 The cash position of the firm increased by 120% in 2006 and 29% in 2007, giving the impression the firm was well capitalized. Further analysis of the cash-flow statement will prove this level of cash was not enough to support the massive losses (write-downs) incurred by the operating side of the businesses. However, the firm cannot finance negative growth; losses from operating activities can’t exceed cash-flows from financing in the long-term. 2. Evaluate the cash flow from Operations
A high divergence between net income and cash from operations equates to low quality of accruals and high quality of accruals equates to high quality of earnings. With higher quality earnings, investors have higher confidence. The divergence ratio increased from .05 to .07 from 2005 to 2007. This indicates to financial statement users that the quality of the firm’s accruals is decreasing, which may be an indicator that the firm will have financial distress in future periods. Report Date 12/28/2007 12/29/2006 12/30/2005
Net earnings (loss) (7,777,000) 7,499,000 5,116,000 Divergence ratio (Net Income-Cash flow from operations/Average Total Assets) 0.07 0.06 0.05 As you can see, the divergence ratio is increasing, which indicates that the quality of the accruals is decreasing. This undercuts investor confidence, as the earnings are considered less reliable. The major loss in CFO was due to “Other changes in loans, notes, & mortgages held for sale,” due to
Richard Hamilton
Mike Rakes
Brandon Sather
Teresa Sexton
Narrative:
Merrill Lynch is financing the business through Cash provided by financing activities – the operating activities loss is offset by increases in long-term borrowings.
1. Evaluate the cash position at year-end
Report Date 12/28/2007 12/29/2006 12/30/2005
Cash & cash equivalents 41,346,000 32,109,000 14,586,000 The cash position of the firm increased by 120% in 2006 and 29% in 2007, giving the impression the firm was well capitalized. Further analysis of the cash-flow statement will prove this level of cash was not enough to support the massive losses (write-downs) incurred by the operating side of the businesses. However, the firm cannot finance negative growth; losses from operating activities can’t exceed cash-flows from financing in the long-term. 2. Evaluate the cash flow from Operations
A high divergence between net income and cash from operations equates to low quality of accruals and high quality of accruals equates to high quality of earnings. With higher quality earnings, investors have higher confidence. The divergence ratio increased from .05 to .07 from 2005 to 2007. This indicates to financial statement users that the quality of the firm’s accruals is decreasing, which may be an indicator that the firm will have financial distress in future periods. Report Date 12/28/2007 12/29/2006 12/30/2005
Net earnings (loss) (7,777,000) 7,499,000 5,116,000 Divergence ratio (Net Income-Cash flow from operations/Average Total Assets) 0.07 0.06 0.05 As you can see, the divergence ratio is increasing, which indicates that the quality of the accruals is decreasing. This undercuts investor confidence, as the earnings are considered less reliable. The major loss in CFO was due to “Other changes in loans, notes, & mortgages held for sale,” due to