Question

Compute and Interpret Coverage, Liquidity and Solvency Ratios Selected balance sheet and income statement information from CVS Health Corp. for 2014 through 2016 follows ($ millions). Total Current Assets Total Current Liabilities EBIT (Operating income) Interest Expense, Gross Total Liabilities Equity 2016 $31,042 $26,250 $10,338 $1,058 $57,628 $36,834 2015 29,158 23,169 9,454 838 55,234 37,203 2014 25,983 19,027 8,799 600 36,224 37,963 a. Compute times interest earned ratio for each year and discuss any trends for each. Round answers to one decimal place. Year TIE Ratio 2016 Answer 2015 Answer 2014 Answer b. Compute the current ratio for each year and discuss any trend in liquidity. Round answers to one decimal place. Year Current Ratio 2016 Answer 2015 Answer 2014 Answer Do you believe the company is sufficiently liquid? Explain. CVS’s current ratio has increased over the past three years and is greater than 1, indicating CVS is liquid. CVS’s current ratio has decreased over the past three years and it is currently less than 1 indicating CVS is not liquid. CVS’s current ratio has increased over the past three years, however, it remains less than 1 indicating CVS is not liquid. CVS’s current ratio has decreased over the past three years, however, it is greater than 1 indicating CVS is liquid. c. Compute the total liabilities-to-equity ratio for each year and discuss any trends for each. Round answers to one decimal place. Year Liabilities to Equity 2016 Answer 2015 Answer 2014 Answer d. What is your overall assessment of the company’s credit risk from the analyses in (a), (b), and (c)? CVS is a low credit risk as it has a low level of debt, is liquid and can easily meet its interest expenses. CVS is a low credit risk as its liabilities to equity ratio, current ratio, and times interest earned ratio have all decreased since 2014. CVS is a medium to high credit risk as its level of debt has increased and its current ratio and times interest ratio have decreased. CVS is a medium to high credit risk as its liabilities to equity ratio, current ratio, and times interest earned ratio have all increased since 2014.

Answer 1

a.

Times Interest Earned Ratio = EBIT / interest Expense

For 2014: $8,799 / $600 = 14.7 times

For 2015: $9,454 / $838 = 11.3 times

For 2016: $10,338 / $1,058 = 9.8 times

The TImes Interest Earned (TIE) Ratio measures the operating income level that can be used for interest payments in the future, i.e. how many times the Company can make the interest payments. It is a solvency ratio since it measures the Company's ability to service it's debt interest obligations. Hence, the higher the ratio, the more favorable is the company's liquidity position.  

In the given question, we can observe that the ratio has consistently decreased year on year. This implies that the Company's debt has increased while the increase in operating income has not been at the same pace. The Company can afford to service interest fewer times each year from 2014 to 2016. This implies that the Company has become comparatively more risky than before from the Creditor's standpoint.

b. Current Ratio = Current Assets / Current Liabilities

For 2014: $25,983 / $19,027 = 1.4

For 2015: $29,158 / $23,169 = 1.3

For 2016: $31,042 / $26,250 = 1.2

The Current Ratio is an indicator of how efficiently the Company manages it's operating cycle. A higher Current Ratio implies that the COmpany is in a better position to discharge all it's short term obligations without affecting or jeopardising it's working capital requirements. On the flipside, a ratio that is too high indicates that the Company's current assets are lying idle or that it is not efficiently using short term funds.  

In the Given case, the Company's current ratio shows a steady decline. However, the lowest is 1.2 times, which implies that the Company is still sufficiently liquid. This is becase even at the lowest, the Company's Current Assets can pay off the Current Liabilities 1.2 times without affecting working capital cycle for regular business needs.  

Hence, as per the options given, we can say that  CVS’s current ratio has decreased over the past three years, however, it is greater than 1 indicating CVS is liquid.  

c. Total Liabilities to Equity Ratio = Total Liabilities / Total Equity

For 2014: $36,224 / $37,963 = 0.95

For 2015: $55,234 / $37,203 = 1.5

For 2016: $57,628 / $36,834 = 1.6

Total Liabilities include all the claims, long term and short term, against the Company's Assets.  Total Liabilities to Equity Ratio indicates how much of the Company's Assets are funded by creditors versus how much is funded by the equity holders. Broadly, a 1:1 ratio is considered acceptable for most industries. Creditors would prefer a lower ratio as this implies their money is at less risk. However, equity holders would like to benefit from the risk taken by them due to the Company using debt, and would prefer a higher ratio.

In the given case, this ratio is increasing year on year. This implies that the COmpany is taking on more debt financing. This implies that the Company has more risk overall, although it benefits the equity holders since the lev. erage from debt offers them higher returns

d. Overall Assessment of the Company's Credit Risk:

Based on the above, it is appropriate to say that CVS is a medium to high credit risk as its level of debt has increased and its current ratio and times interest ratio have decreased.

The rising Total Liabilities to Equity Ratios Coupled with Lowering Interest coverage ratios indicate an increasing level of debt.  

Further, lowering current ratio and interest coverage ratio also indicate a reducing liquidity level, possibly decreasing the ability of the COmpany to meet it's debt and other financial obligations from it's business income. These factors make the Company riskier in terms of credit risk.