GUIDE TO ANALYSIS OF FINANCIAL CAPABILITIES
FOR PREAWARD AND POSTAWARD REVIEWS


Table of Contents:

SECTION I - Introduction
     Purpose
     Financial Analysis
     Role of the DCMA Analyst
     Importance of the Assessment
     Implications of Prediction
     Changes to this Guide
 SECTION II - PREAWARD SURVEY (PAS) PROCESS
     A Team Effort - Production, Quality, and Finance
     Purpose of the Financial Preaward Analyses
 SECTION III - PERFORMING THE FINANCIAL PREAWARD ANALYSIS
     Obtaining Financial Information
     Beginning the Financial Preaward Survey
     Preliminary Review of the Offerors Financial Data
     Contact the Offerors Banker
     In-depth Systematic Statement Analysis
     Consolidated Financial Statements
 SECTION IV - ANALYSIS
     Basic Comparisons
     Ratios
     Horizontal Analysis
     Vertical Analysis
     Common-Size Statements
     Analysis of Financial Trend
     Interpretation of Analyses
 SECTION V - CLASSIFICATION OF ACCOUNTS
     Assets
     Capital Accounts
 SECTION VI - AREAS OF ANALYSIS
     Working Capital Analysis
     Bank Restrictions on Debts
     Secured Loans and Their Terms
     Payroll Tax Liability
     Offeror in Bankruptcy
     Cash Flow Projection
     Possible Problem Areas
     Recording of Financial Data
 SECTION VII - WORKING CAPITAL
     Reconciling Working Capital
     How the Offeror Can Indirectly Improve Financial Condition
     Obtaining Additional Fixed Assets
     Progress Payments
 SECTION VIII - COMPLETING THE PREAWARD FINANCIAL SURVEY
     Completing Section I of SF 1407
     Supervisory Review of Preaward Surveys
     Maintain the Financial File
 SECTION IX - FINANCIAL PREAWARD ON A PRIOR OFFEROR
     Updating Financial Data
     Depth of Analysis
 SECTION X - POSTAWARD FINANCIAL SURVEILLANCE
     Extent of Coverage of the Postaward and Frequency of Performance
     Arranging for Submission of Financial Data
     Reviewing the Data and Reporting the Results
     Summary
 APPENDIX A - SOME SOURCES OF FINANCIAL DATA
 APPENDIX B - FURTHER READINGS
 APPENDIX C - FINANCIAL RATIOS
     Solvency Ratios
     Working Capital Ratios
     Leverage Ratios
     Coverage Ratios
     Profitability Ratios
 APPENDIX D - BANKRUPTCY PREDICTION
 APPENDIX E - FORMS
SECTION I - Introduction

A.    Purpose

The purpose of this publication is to serve as a guide for the DCMA analyst performing an analysis of a contractor's financial capability as part of a preaward or postaward review.  While this Guide does not have the force of a regulation, it is recommended that the file be documented with a rationale should a variant approach be selected. 

B.    Financial Analysis

In business literature, "financial analysis” means "securities analysis” and refers to the study of investment opportunities. Techniques used in the analysis of corporate financial capabilities are the same as those used in securities analysis; however, their purpose and emphasis may differ. 

The Government must determine whether a potential contractor has the financial resources to fulfill contractual requirements, while the investing community is interested in accurate estimates of future earnings.  Corporate bond ratings provide a market assessment of the issuer's ability to meet future payment obligations.  Stock quotations reflect the market's estimate of the value of future earnings.  Inherent in both estimates is a determination that the corporation has the financial wherewithal to remain in business. The Government analyst assesses the same data from the perspective of a customer and creditor.  The Government is also interested in assessing the long term viability of the industrial base.  

C.   Role of the DCMA Analyst

Definition.   "DCMA Analyst"  is the generic title used in this document to cover all General Service 1102 Series Contract Administrators within DCMA who perform financial analysis reviews.
Responsibilities
:   The DCMA Analyst is primarily responsible for evaluating current and potential suppliers’ financial capability to fulfill contractual requirements.  The main tasks in this responsibility fall into the following areas:

     1.  Preaward analysis of financial statements requested as part of a Pre- award Survey.

    2.  Postaward financial analysis/ risk mentoring  when the contracts are administered by the Defense Contract Management Agency, particularly for those contractors where Government financing is being  provided and when financial capabilities are marginal.

    3.  Predictive Analysis: An analyst may be asked to provide feedback on the current financial status of a contractor for a customer as a preliminary measure or for other business related concerns.  Discuss the request in depth with the customer and understand what the customer is looking for/what is actually needed in order to answer the customers concerns.  If there has been a recent review, for instance within the last 3-4 months on the contractor, then the analyst could advise the customer of the contractor’s current financial status based on this last review.  If the review was done more than 4 months ago, or, if there is some indication or concern that the company's financial condition has changed significantly, then the analyst will need to perform the Altman's Z-Score  to see what it indicates and check current information in commercial ratings that DCMA may have access to, such as (but not limited to) reports from Dun and Bradstreet (D&B),  or stock ratings if publicly held. Look at the trends of the contractor's particular industry. From these indicators, it may be obvious that it is necessary to perform a comprehensive review at this time. Network with other DCMA analysts and check Financial Analysis under the Pricing Community of Practice (CoP) on the Knowledge Management web site to see what successful practices on predictive analysis are in place that could be used or tailored to meet the needs of the current request. There may be a successful practice within DCMA that could be adopted at your Contract Management Office (CMO) for  predictive analysis related to financial condition reviews.

    4.  Maintaining appropriate files and records of financial statements and reports reviewed.   

D.   Importance of the Assessment

A healthy financial position can enable a contractor to overcome shortcomings discovered during a Preaward Survey.  It permits the acquisition of needed labor, technology, or capital equipment.  On the other hand a weak financial position may result in financial failure of a contractor, leaving it unable to fulfill the contract. 

E.    Implications of Prediction:  

An analyst's assessment of a contractor's financial capability to fulfill contractual requirements is a judgment call, derived after thorough analysis.  It is necessary to be able to defend your assessment. The assessment can best be defended if you utilize most or all analytical techniques discussed in this guide and apply your expertise to make the final decision.  Always make it known that your prediction is an opinion based on information available for review/information reviewed and/or forecasted. 

F.    Changes to this Guide

Suggested changes and additions are solicited and should be submitted to: 

Defense Contract Management Agency
ATTN:  DCMA OCB, Elaine Philpott
6350 Walker Lane

Alexandria, VA 22310

(703) 428-0985
FAX 428-1368

 

SECTION II - PREAWARD SURVEY (PAS) PROCESS 

A.  A Team Effort - Production, Quality, and Finance 

When a financial capability review is requested to be done, included along with other technical reviews during the PAS , recognize the PAS evaluation is a team effort.  The recommendations and findings of one member may impact upon those of other members. Therefore, when a deficiency is found that could affect another member’s recommendation, bring the deficiency to the attention of that member through the Preaward Monitor.  Lack of communication among team members could result in an affirmative pre-award recommendation when a negative pre-award recommendation should have been made, or vice versa.  An example of failure to coordinate properly can be cited in a real life situation, where a contractor could not perform because it did not have sufficient equipment.  In this case, the contract had to be terminated within two weeks after award and another awarded. 

    1.  In the survey just mentioned, the production report showed that the offeror would require additional equipment to perform the work.  Insufficient working capital prevented the potential contractor from purchasing, leasing, or renting the necessary equipment.  However, the DCMA  Analyst's report did not reveal that any additional financing for equipment would be required to perform the work.  Each team member must inform the Preaward Monitor of critical data which could impact the PAS. 

    2.  If the PAS monitor reports something found by another PAS member which might affect the financial capability recommendation, the DCMA Analyst must determine whether it has already been considered in the financial analysis.  When necessary, the contractor should be asked if additional costs required to obtain test equipment, production facilities, etc., were considered.  Any new information must be considered in making the financial capability recommendation.  There are other types of information which can impact upon the PAS, i.e., potential labor interruptions, lack of skilled labor, pending reorganization of the company, potential bankruptcy, too much business volume for present working capital, etc.  Team members must communicate to produce a quality PAS for the customer.

B.  Purpose of the Financial Preaward Analyses

The analyst's main PAS objective is to determine if the potential contractor can stay in business long enough to complete existing and potential contract work; but time constraints for preaward review can make this task difficult.  Unless a review of the contractor's certified statements uncovers something obviously erroneous and of a material nature, the analyst can only assume that the statements are accurate.  The contractor's or its accountant's certification is required. 

If the potential contractor is currently undergoing or contemplating bankruptcy procedures, the DCMA Office of Counsel will be consulted before making a final recommendation.  The recommendations of counsel and the analyst should be summarized in Section VI, Block 6, of the SF 1407.
 

SECTION III - PERFORMING THE FINANCIAL PREAWARD ANALYSIS 

A.  Obtaining Financial Information

    1.  Normally, financial information concerning a specific contractor is obtained directly from that contractor.  It is usually more current than information from secondary sources, such as those listed in Appendix A, "Some Sources of Financial Data."  However, these sources recommended in appendix for industry and economic information can be very useful for comparison and forecasting. 

    2.  Site visits are the preferred approach for clarifying information with the contractor/supplier.  Site visits are most useful after an analyst has studied the available information concerning the contractor's products, markets, financial history, competitive position, and goals.  Analysis of such information will likely result in a number of questions that should be arranged in some logical sequence as preparation for the site visit.

        B.  Beginning the Financial Preaward Survey

Key areas for determining financial strength are the company's profit record, net worth, sales, cash flow and projections.  Financial analysis of major subcontractors should be considered.  Always discuss this area with the PAS Monitor  before proceeding. 

    1.  Receiving and Processing the Request to Perform a Financial Analysis

        a.  A request is received from the PAS monitor to perform a financial capability analysis during the pre-award stage.  A request is normally received from a Contracting Officer to perform Post-award reviews. It can be from an Administrative Contracting Officer (ACO)  or Procuring Contracting Officer ( PCO).

        b.  The request is usually made via a SF Form 1403, "Preaward Survey of Prospective Contractor - (General) for Pre-award financial reviews." https://home.dcma.mil/onebook/1.0/1.2/Preaward.htm#3.6. Risk Documentation

        c.  The DCMA Analyst should assure that the following data are included in the survey request:  (i) dollar amount of proposed contract, (ii) type of contract, (iii) item description, (iv) delivery schedule, (v) Government financing required, and (vi) identification of requesting element and phone number. 

        d.  Additionally, the analyst should assure that the request shows the name, title, and phone number of the firm's representative who will respond to financial inquiries. 

        e.  Ask the PAS monitor if the requestor of the PAS has indicated that the proposed contract price appears too low.  This could indicate financial problems.

        f.  Any needed information not supplied with the SF 1403 should be requested from the PAS monitor. 

    2.  Firms with Potential Financial Weaknesses. Understand the firm, the type of legal entity you are reviewing.   Firms that require special attention because of their potential financial weaknesses are: 

        a.  New suppliers or newly organized companies. 

        b.  Contractors with a past history of defaults or delinquencies. 

        c.  Companies with rapidly expanding business volume. There is a risk of overextending financial resources (working capital and facilities expansion). 

        d.  Companies that are within a multi-structured corporation,  under a parent or holding company and they don’t have control over their  working capital or cash flow. 

         e.  Small companies.  They frequently have limited capital and often are poorer risks than large companies, since they are less able to absorb financial losses. 

                f.  Companies refusing to disclose information about their financial condition:  Such a refusal may merely reflect the firm's normal policy, but it may also be an attempt to hide financial weaknesses.  In any event, such firms should be assured that financial data submitted will be used solely for determining financial adequacy and will not be otherwise disclosed.  A firm that refuses to submit data should be informed that a refusal may have a potential adverse effect on the DCMA Analyst's recommendation and a possible loss of the proposed contract.

                f.  Firms where other known conditions raise reasonable doubts as to financial strength. 

    3.  Check the CMO Financial Files.  Prior to contacting the offeror, the DCMA Analyst should check the financial files to determine if the offeror is a new bidder at this DCMA office.  If the prospective contractor is a current contractor, or a frequent bidder, the DCMA office may have adequate financial information to evaluate the firm's financial capability to perform. 

    4.  Contact the Offeror.  If current financial data are not available, the DCMA Analyst should immediately contact the prospective contractor and request relevant financial information for evaluation: 

        a.  Copy of the firm's interim financial statements and the previous two completed years annual reports or financial statements.

         b.  Cash flow statements and/or forecasted cash flow projections, if applicable.  Smaller companies normally won't have these.  The statement of cash flow will be available with the annual financial statements for any company required to file with the Securities and Exchange Commission (SEC).  See further information on the review of cash flow statements below under "Analysis" at F, the contracting officer should/may request one..  Where there are no cash flow statements or cash flow  forecast, ensure you get as much information as possible to ascertain whether the company has sufficient working capital:.

                b.  Aged accounts payables and aged accounts receivables.

                d.  Statement of current dollar amount of the company's backlog of orders, broken out by Government and Commercial, and the proposed monthly delivery schedules. Obtain the approximate date of completion of  the contract with the longest remaining period of performance.

         e.  Approximate date of completion of the contract with the longest remaining period of performance.

         e.  If a service contractor, the monthly billing for both government and  Commercial.

         g.  In addition, the DCMA Analyst should determine:

                    (i)  The  type organization,  such as proprietorship, partnership,  or  corporation.  The top level parent if the company being reviewed is a subsidiary or business unit.

                    (ii)  The date the  firm's  fiscal year ends.

                    (iii)  Name and address of its bank,  the bank's telephone  number, and the name of the bank official most familiar with  the contractor.

                    (iv)  Will this be a loss contract?

                    (v)  Will additional capital equipment be required?

                    (vi)  Type of  financial resources the offeror believes will  be  required to perform the contract.

                    (vii)   Any liens or judgments outstanding.

                    (viii)  Does the contractor/ potential contractor (bidder) control his own bank accounts or does a parent organization control the accounts?  If the  contractor operating unit that is to perform the work does not control the accounts, have  cash management,  then steps should be taken to ensure the availability of adequate capital to perform the contract.  The surest means would be to obtain a parent guaranty agreement.  A guaranty will make the parent or holding company financially responsible where the performing unit does not control its cash. ( link Guaranty form)

            5.  Certification of  Financial  Statements.   The DCMA Analyst should advise the firm's representative that if the financial statements are not certified by an independent Certified Public Accountant (CPA), they should be signed by an officer of the company.  In case of a qualified certification by an independent CPA firm, any exception(s) should be thoroughly reviewed and made a part of the analyst's final recommendations, as appropriate.   Always read footnotes,  comments made explaining certain accounting procedures and classifications used, and background information deemed necessary to evaluate the statements.    Inquire, ask questions of the contractor as necessary . The following should be noted:

                a.  Information concerning profits.

                b.  Non-recurring gains;  such as the sale of a subsidiary.

                c.  Change(s) in accounting practice(s).

                d.  Potential lawsuit(s)/liabilities.

                e.  Recorded  Liens and/or Court Judgments. Prior subordination agreements in place.

Where the certifications are not made by an independent CPA firm,  request the offeror to use the following certification: 

"This is to certify that to the best of my knowledge and  belief  the financial  data and the accompanying notes to the financial statements are accurate and complete and prepared in accordance with Generally Accepted Accounting Procedures from the company's general accounting records.   The descriptions and amounts are based upon  the _____________________  method of accounting and reflect the company’s  financial status as of

(Date) _______________

Date __________________                          Signed_________________________
                                                                     Title

If  an offeror is unable, or unwilling to comply with requests for necessary financial  information,  the DCMA Analyst will find the offeror unsatisfactory and recommend no award.   The burden for demonstrating financial responsibility rests with the offeror.

    C.  Preliminary Review of the Offeror's Financial  Data: 

Upon receipt of the firm's financial statements and other requested financial  information,  a preliminary review should be made to determine if the data are adequate.   For example:

        1.  Does  the  information appear to be fully disclosed?   How do you know?

2.  Are the footnotes to the financial statements informative?

        3.  Is the data certified by the offeror or a CPA firm ? ( See certification language above if it is certified form within the company) 

    D.  Contact the Offeror's Banker

The offeror's  bank should be contacted to obtain the following information:

1.  The bank’s experience with the offeror regarding accounts on deposit and loan accounts.

2.  The offeror 's total  line of credit and how much is in use.

3.  A bank commitment letter should reference the solicitation number which is referenced in the resulting contract.  Determine if the offeror has requested financing for the proposed contract under consideration.  If so, a firm commitment of financing should be obtained in writing from the bank.  It should specifically identify the terms and conditions under which the bank will give the offeror a certain amount of credit.

4.  Assignment:   The offeror may want to assign the awarded contract to the bank.  These arrangements should be made by the offeror.  The contractor's right to contract payment can be used to obtain private financing.  Such an assignment provides security for a loan to finance the instant contract.  The lender or assignee then receives contract payments directly from the Government.  These assignments are authorized by the Assignment of Claims Act of 1940, as amended (Title 31, U.S.C. 3727 and Title 41, U.S.C. 15).  The standard Assignment of Claims clause (FAR 52.232-23) is included in contracts and reflects the terms of the act.  The right to assign claims promotes financing without involving the Government in banking.  After an assignment is made, the bank administers the financing.  The assignment must cover all amounts remaining to be paid on a contract.  It may not be split between two or more parties but an assignment may be made to one party acting as agent or trustee for two or more parties taking part in the financing.  (See FAR 32.8 and DFARS 232.8 for guidance). Typically, the contractor will work through the ACO on the Assignment of Claims set up when the clause is in the contract and it is delegated to DCMA.

            5.  Special Bank Accounts: Are there any special bank accounts set up?  FAR 32 allows for setting up these special accounts where it is in the best interest of the Government to ensure the money is used on the contract work that it was loaned for/provided for. In this case and where DCMA had contract administration, it is the ACO who administers the accounts. Typically and historically these special accounts have been used where there is Advance Payments ( DFARS 232.4).

        F.  In-depth Systematic Statement Analysis:

The use of a systematic and orderly approach to analyzing financial data saves time for DCMA Analysts.  The task should always be undertaken in the same fashion.  This prevents confusion and assures that no essential details are overlooked.  It should result in a report that is organized and conclusive.  The analyst should not accept promises from bankers, offerors, and others.  The analyst must have confirming letters or other kinds of documents to support recommendations.  No final recommendation regarding financial capability should be made until confirming letters or other kinds of documents are in order.

G.  Consolidated Financial Statements

The purpose of a consolidated statement is to present the results of operations and the financial position of a parent company and its subsidiaries to the shareholders and creditors of the parent company.  Consolidated statements may be more meaningful than separate statements where one of the companies in the group directly or indirectly has a controlling financial interest in the other companies.  However, the DCMA Analyst should request a breakdown of the statement of the individual subsidiaries.  The parent company may have the working papers used to structure the consolidated statements. 

Within the corporate structure, one or more of the subsidiaries, and possibly the holding company, may be weak, while the offeror, one of the subsidiaries, is strong.  It is possible the holding company could divert funds from the strong to the weak business segments and in the process weaken the financial structure of the stronger segment.  As a practical matter when a prospective offeror is a subsidiary of another company and independent statements are not available, or there are indicated weaknesses in a consolidated statement, the DCMA Analyst should attempt to secure a guarantee. agreement from the parent company. Seek the Administrative Contracting Officer’s (ACO) support if necessary to obtain it.  If the contractor owes money to the parent company, the analyst should also attempt to secure a subordination agreement from the parent. If the contractor owes money to other entities or banks, seek a subordination agreement.  DCMA has recommended generic type forms but in some cases the contractor may want to use their own guaranty or subordination form.  Always seek  DCMA legal counsel review when working with guarantees and subordination agreements that are not those that use the standard  DCMA Form 1619  for  Subordination Agreements and DCMA Form 1620 for Guaranty Agreements.   The purpose for these agreements, signed forms, is to protect the Government’s interest.  Make sure that is clearly done; work with the ACO , DACO or Corporate ACO as necessary as well as DCMA Legal Counsel.

SECTION IV - ANALYSIS 

A.  Basic Comparisons

For purposes of comparison, financial data are often expressed as percentages or ratios.  These comparisons may represent: 

            1.  Percentage increases and decreases in a specific item between comparative financial statements (Horizontal Analysis),

            2.  Percentage relationships of individual components to an aggregate total in a single financial statement (Vertical Analysis), or

            3.  Ratios of one amount to another in the financial statements. 

        B.  Ratios:

            1.  The meaningful use of ratios requires both a logical relationship between the figures and that users clearly understand the relation ship.

            2. The value of ratios is to identify possible areas of financial weakness or strength.

            3.  See Appendix C for some commonly used ratios and their interpretations.

            4.  It must be borne in mind that in statement analysis, any single ratio may have little meaning unless related to the circumstances reflected by other ratios.  For example, a firm having a large capital turnover with rapid movement of inventory, low return on sales, but adequate return on worth, may be properly financed for its operations even though the current ratio is low.

        C.   Horizontal Analysis

Analysis of increases or decreases in a given financial statement item over two or more accounting periods is often referred to as horizontal analysis.  Generally, this type of analysis discloses both the dollar and percentage changes for the corresponding items in comparative statements.

        D.   Vertical Analysis

The percentage relationship of an individual item or component of a single financial statement to an aggregate total in the same statement often discloses significant relation ships.  These relationships may be useful information for decision-making purposes.  For example, in reporting income data, it may be useful to indicate the relation ship between sales and other elements of the income statement for a period.  This analysis of the elements included in the financial statements of a single period is often referred to as vertical analysis. 

E.  Common-Size Statements

Horizontal and vertical analyses are frequently useful in disclosing certain relationships and trends in individual elements included in the financial statements.  The analysis of these relationships may be facilitated by the use of common-size statements, i.e., statements in which all items are stated in terms of percentages or ratios.  Common-size statements may be prepared in order to compare data from the current period with that from one or more past periods for a firm.  These statements may also be used to compare data of two or more business firms for the same period or periods, subject to the limitations mentioned previously. 

F.  Analysis of Financial Trend:          

 An analysis is made to find out what direction a concern is going, how rapidly, and whether there are enough resources to complete the proposed contract.  Following is an analysis plan:

 

            1.  From the operating statement observe the amount of earnings for the year and the dividends paid.  From the balance sheet observe changes in capital stock, and from the surplus reconciliation review the adjustments charged or credited directly to surplus.

           

            2.  Study the earning records for the past several years to ascertain trend of sales, profits and/or losses.

 

            3.  If operating details are lacking, draw conclusions from the change in earned surplus,  capital stock, and provision for income taxes.

 

            4.  Analyze the gain or loss reflected in working capital.

 

            5.  Determine if net fixed assets (assets - depreciation) have increased or decreased.

 

            6.  Review the reduction or increase in non-current liabilities.  Now determine if the changes in the balance sheet and operating statements have strengthened or weakened the company's general financial position.

     7. Cash Flow Statements and Cash Flow Forecasts are needed when there is doubt regarding the sufficiency of a contractors cash flow. DFARS has guidance at  DFARS 232.072-3 Cash flow forecasts.

 

        G.  Interpretation of Analyses

The user must exercise caution in the use of ratios in order to analyze the financial statements of a business enterprise.  Some of the problems inherent in ratio analysis are summarized below. 

    1.  Comparisons of items for different companies may not be valid if different accounting practices have been used.  For example, one firm may use straight-line depreciation and the FIFO inventory method while a similar company may use accelerated depreciation and LIFO for its inventories.

            2.  Financial statements represent only one source of financial information concerning a firm and its environment.  Consequently, other information not disclosed in financial statements may have an impact on the evaluation of the statements.

    3.  Most financial statements are not adjusted either for changes in market values or in the general price level.  This may seriously affect comparability between firms over time.

    4.  As ratio analysis has increased in popularity, there has sometimes been a tendency to develop ratios which have little or no significance.  A meaningful ratio can be developed only from items which have a logical relationship. 

SECTION V - CLASSIFICATION OF ACCOUNTS 

The following comments recommend specific treatment of the various statement accounts.  In some cases there may be differences of opinion among Analysts in the classification of certain accounts, but to provide a systematic approach to the problem it is suggested that the following recommendations be followed in the interests of uniformity, unless special circumstances warrant deviation. 

        A.  Assets:

            1.  Current assets, also called trading assets, include cash, trade receivables, and inventory.  These are items that can be converted to cash within one year or in the normal operating cycle of a business.  Also included in this category are any assets held that can be readily turned into cash with little effort, such as Government and marketable securities.

        a.  Cash.  Cash in bank and on hand are included.  However, only "free" cash shall be classified as a current asset.  Cash shall include only unrestricted cash that is freely available for withdrawal to meet liabilities of the company as they mature.  Any amounts subject to restrictions, as cash set aside in special funds to meet sinking fund requirements or to pay specific debts, cash in closed banks, or frozen deposits in foreign countries shall be transferred and classified as other assets.  If the statement shows an overdraft in the liabilities, the amount of the deficit shall be transferred to current assets as a red figure (credit) and both current assets and liabilities reduced accordingly.  A rule of thumb is that cash position is generally strongest after the peak selling season.

                b.  Marketable Securities.  Marketable securities consist of US. Government obligations, State and Municipal obligations, Corporate Securities, and Money Market instruments.  Only securities listed for trade through a licensed brokerage firm shall be included in this classification and valuations shall be shown at the lower of cost or market value.  Non-listed securities should be classified under other assets as "Stocks and Bonds.”   Marketable securities are usually listed at cost or market price, whichever is lower. Accountants will frequently list securities at cost with a footnote indicating market price on the balance sheet date.  (When marketable securities appear on a statement, it frequently indicates investment of excess cash.)

        c.  Accounts Receivable.

            (i)  Accounts receivable indicate sales made and billed  to customers on credit terms and are often the largest item on a balance sheet (position statement).  It consists of customer accounts receivable, receivables due from subsidiary or affiliated companies, receivables due from employees, officers, stock holders, directors or principals, and special receivables.  Only customer accounts receivable arising from the sale of company products shall be classified as current assets.  They shall be shown at net value, after deducting a reserve for discounts and anticipated bad debts. Aging of accounts receivable is very desirable for determining slowness in collecting from customers.  For example, when the credit terms are net 30 days, any accounts older than 30 days would indicate a slowness in collecting from customers.  Accounts over 90 days old should be classified as other assets.  However, there are lines of business that extend liberal credit terms and in such cases the classification of accounts will have to be tempered accordingly. It is important where sales are given to note the companions of receivables at the date of the statement to sales for the period. This comparison may indicate that the company has receivables on its books representing many months of business.  A key indicator of a company's health is timely collection of receivables.

            (ii)  Accounts receivable that have not arisen in the ordinary course of business, such as the receivables due from employees, officers, stockholders, directors, or principals, and any special receivables, should be transferred and classified "as other assets."

        d.  Notes Receivable.  Notes receivable represent a variety of obligations with terms coming due within a year.  Only notes receivable arising from sales such as in connection with installment sales, shall be classified as current assets.  All notes receivable shall be scrutinized carefully to ascertain whether they were accepted for past due accounts receivable or for notes due from officers, stockholders, partners, relatives, or friends.  Notes receivable accepted for such cases shall be transferred and classified as other assets.  Notes representing advances made to subsidiary or affiliated companies shall be shown as a separate account; if the amount of the account is large, it may be desirable to obtain the subsidiary's or affiliated company's financial statement to ascertain its financial condition.

        e.  Inventory.  Inventory is the most difficult asset to value accurately.  However, only inventory that is good and saleable shall be classified as a current asset.  Many manufacturers show three different classes of inventory:  raw materials, work-in-process, and finished goods.  Raw materials are considered the most valuable part of inventory as they could be resold in the event of liquidation.  Work-in-process has the least value because it requires additional labor and a sales effort, if liquidation should occur.  Finished goods are ready for resale.  Finished goods values vary greatly according to circumstances.  If the goods are popular products in good condition and can be easily sold, then a high value might be justified.  If the goods are questionable, their value may be low.  The manufacturer's costs of labor employed in the production of finished goods and goods in process, as well as factory expenses, are included in the value.  Inventory is normally shown on the balance sheet at cost or market value, whichever is lower.

As a company’s sales volume increases, larger inventories are required; however, problems can arise in financing their purchase unless turnover, the number of times a year goods are bought and sold, is kept in balance with sales.  A sales decline should be accompanied by a decrease in inventory in order to maintain a healthy condition.  If a business has a sizable inventory, it may own partially completed or finished goods that are obsolete, or it could reflect a change in merchandising conditions.

    2.  Other Current Assets.  This category includes prepaid insurance, taxes, rent, and interest.  Some analysts consider prepaid items as non-current because they cannot be converted to cash to pay obligations quickly, and therefore have no value to creditors.  Normally, this category is not large in relation to other balance sheet items, but if it is sizable there may be problems.

                a.  Cash Surrender Value of Life Insurance.  When Cash Surrender Value of Life Insurance is listed as a current asset, it should be transferred and classified as other assets.  This asset, as in the case of prepaid assets, does not meet the normal test of a current asset.  In the ordinary course of business, this asset will not become available for payment of current debts.  The Analyst must keep in mind the high liquidating value of the cash surrender value of life insurance policies and the ease of obtaining loans to meet current requirements by pledging this asset.  When a company borrows against such policies it may want to keep its investment intact, while repaying the loan by liquidating inventories or receivables, or through profits, rather than by converting this asset to cash.

         b.  Uncompleted Contracts, or Work in Process.  Some companies’ statements may show these accounts representing material and labor incurred for a job which is not complete.  Such an account should be classified as a current asset.  However,  the Price/Cost Analyst should ascertain whether the amount shown is at actual cost or whether it includes profit.  Profit sometimes disappears before the contracts are finished.

         c.  Prepaid Expenses.  The amount of prepaid expenses included in current assets, unless the amount is nominal when compared with working capital, should be classified as “other assets” or “deferred assets” as the case may be.  Most creditors consider current assets as those which are available, or will become available in the ordinary course of business, for payment of current liabilities.  Prepaid expenses do not meet such test and are considered non-current assets.

         d.  Tax Refunds.  If tax refunds are included in current assets and the amount is important to the analysis, effort should be made to determine to what extent the Internal Revenue Service has approved the refund, and when payment is expected.  Normally, payment of a tax refund can be expected within 90 days of filing a tax return.  When the status of collection is undeterminable, or if the amount is in dispute between the company and the Internal Revenue Service, the account should be transferred and classified as other assets.

         e.  Other Accounts.  If there are other accounts included in current assets that are difficult to identify because of the unusual terminology associated with the account, further investigation may be required to properly identify the account and determine whether it should be included in “current assets” or transferred and classified as “other assets.”

     3.  Non-current Assets.  Non-current Assets are items a business cannot easily turn into cash and are not consumed within business cycle activity.  Current assets can be converted into cash within one year.  Non-current assets have a life exceeding a year. 

        a.  Fixed Assets.  Fixed assets are materials, goods, services, and land used in production.  Examples include:  real estate, buildings, plant equipment, tools and machinery, furniture, fixtures, office or store equipment, and transportation equipment. All of these have to be used to produce products for a company's customers.  Land, equipment, or buildings not used to produce customer goods are listed as "other noncurrent assets" or "investments."  Fixed assets are carried on the company’s accounting books at the amount they cost at the time of purchase.

All fixed assets, except for land, are regularly depreciated since they eventually wear out.  Depreciation is an accounting practice that reduces the fixed asset's carrying value on an annual basis.  The reductions are considered a cost of doing business and are called a depreciation charge. Eventually the fixed asset will be reduced to its salvage or scrap value.  A  piece of equipment may continue to be fully productive long after it has been completely depreciated to scrap value.  Normally, the accounting procedure is to list the fixed asset cost less accumulated depreciation, which would be shown on the statement or in a footnote.  Not all companies can be comparable on this item, since some rent their equipment and premises.  If a business rents, its fixed asset total will be smaller compared with other balance sheet items.

            (i)  Plant.  Some companies show plant separate from equipment, furniture, fixtures, etc., while others group them together.  If the reserve for depreciation is shown on plant, the amount is deducted from the plant amount.  If a separate reserve for depreciation is shown for equipment, furniture, fixtures, etc., this should be grouped under equipment after deducting the depreciation reserve.  If the company shows only one reserve for depreciation against fixed assets, the plant and equipment should be grouped together, deducting the reserve and showing the account as plant and equipment, net.  The object is to pursue a uniform classification so that a comparison will be handled the same way each year.  If the depreciation is deducted from the asset account one year and not the following year, the comparison is meaningless.  Occasionally a statement will show fixed assets at the appraised or appreciated value.  When this occurs, the increase in asset value will be included in the net worth section as "appreciation surplus" or "appraisal surplus."  Such net worth is not normally considered tangible net worth for the reason that it is an unrealized capital gain.  It is proper to deduct such "appraisal surplus" accounts from both fixed assets and net worth.

            (ii)  Equipment.  Equipment accounts such as machinery, furniture, fixtures, automobiles, etc., may be shown separately.  However, it is preferable to group plant and equipment into one account, as plant and equipment.  If the company does not own the real estate and plant, such accounts should be shown under Equipment.

            (iii)  Other Real Estate.  Usually this will include real estate which is not a part of the plant.  If this account is shown as net real estate equity, it should be marked so that it is understood that the statement does not show the amount of indebtedness.  If the indebtedness is shown deducted from the account, this amount should be transferred and classified in the appropriate liabilities section, and the full amount of the account should be shown in the asset section.

        b.  Other Assets:

             (i)  Stocks and Bonds.  Included in this account are the non-listed securities as referenced under marketable securities above.  If the statement shows a significant amount invested in the stock or bonds of another company, the account may be better shown separately.

            (ii)  Investment in Subsidiary Companies.  If the statement shows substantial amounts invested in subsidiary companies, the classification should be shown as Investment (name of company).  As mentioned under notes receivable above, it is important to look into the financial condition of the affiliated or subsidiary company.

                    (iii)  Prepaid Expenses and Deferred Charges.  These accounts include prepaid insurance, prepaid rent, prepaid taxes, prepaid interest, office supplies, etc.  If prepaid expense accounts are included under current assets, they should be deducted and classified as prepaid expenses under other assets or prepaid and deferred assets, depending on the form of statement used.

                    (iv)  Intangible Assets.  Intangible assets are those assets usually not available for payment of the debts of a going concern.  These accounts include goodwill, patents, copyrights, mailing lists, catalogues, trademarks, organization expense, drawings, dies, cuts, patterns, stock expenses, etc.  While such assets may represent considerable value to a going concern, they have little if any value for credit purposes.  They depreciate greatly in the event of liquidation of the company.  Treasury stock, which was issued as capital stock but reacquired by the company, is sometimes listed as an intangible asset, but is more properly shown as an offset to net worth.  Treasury stock should be valued at acquisition cost. All intangible accounts should be marked and the total amount deducted from capital and surplus to arrive at the tangible net worth.

            (v)  Due from Officers or Stockholders.  Amounts due the company from officers, stock holders, employees, etc., should be classified as other assets.  if the amount is significant and is increasing, it is obvious that officers or stockholders have been drawing money out of the company.

            (vi)  Mortgages and Real Estate Contracts.  Mortgages and real estate contracts are investment type assets, not used by the company in its operations.  Since they frequently lack the liquidity and marketability characteristics of marketable securities, these accounts should be classified as other assets.

            (vii)  Miscellaneous Assets.  Claims and miscellaneous accounts should be classified as other assets.  Generally, little consideration is given to their availability for payment of debts, unless the likelihood of their collectibility can be ascertained.

        B.  Liabilities:

    1.  Current Liabilities.  Current liabilities are obligations that a business must pay within a year.  Generally, they are obligations that are due by a specific date, usually within 30 to 90 days of fulfillment.  However, generally recognized trade practices may be followed with respect to the exclusion of accounts such as customer's deposits and deferred income, provided an appropriate explanation of the circumstances is made. 

         a.  Notes Payable.  Notes payable should be broken down as follows:

                    (i)  Notes payable to bank.

                        (a)  Bank loans listed under current liabilities are to be retired within a year.  Bank borrowing needs generally will increase along with the company's growth.

                        (b)  Some companies have a line of credit (a limit up to which it can borrow) as a bank customer, which is also a sign that it is regarded as a good risk.  This line is used by companies frequently during peak selling seasons.

                 (c)  If a business has borrowed from a bank without collateral, the bank loan would be considered unsecured (no collateral pledged).  It shows the business has an alternative credit source available other than suppliers, and the business meets the strict requirements of a bank.  On the other hand, if collateral has been pledged, then the loan would be listed as secured.  It is noted that loans might be secured by pledging the owner’s personal property, or real estate, as collateral.

                        (d)  Notes payable to banks should always show bank loans as a liability, and never as an offset against an asset.  When bank loans are offset against an asset it gives a distorted balance sheet presentation.

                    (ii)  Notes payable to officers or stockholders of affiliated companies.  Notes payable to officers or stockholders of affiliated companies are considered loans from friendly sources.

                    (iii)  Notes payable to the trade.  A company may have a credit agreement with suppliers for merchandise or materials.

                    (iv)  Notes payable to others.

                        (a)  If the notes payable to a friendly concern or principal are sizable and have a pronounced affect on the company's overall financial condition, consideration should be given to obtaining a subordination of the loan.

                        (b)  If a company shows outstanding notes and it is not in an industry that traditionally deals in then, this may indicate a weak credit standing.

        b.  Accounts Payable.  Accounts payable represent merchandise or material requirements purchased on credit terms and not paid.  Companies able to obtain bank loans frequently show small accounts payable relative to all of their current liabilities.  The loans are often used to cover material and merchandise obligations. Sizable payables shown, when there are loans outstanding, may indicate special credit terms being extended by suppliers or poor timing of purchases.  Accounts payable should include only those accounts arising out of merchandise transactions on open account terms.

                c.  Accrued Liabilities.  Accrued expenses at the close of the fiscal or calendar year, as well as for any other interim period, are current liabilities.  Such accounts as wages, salaries, taxes, and interest accrued are often omitted from balance sheets, either through oversight or intentionally.  Failure to include these results in understatement of liabilities and overstatement of both working capital and net worth.

                    (i)  Reserve for Taxes.  Where the information is available, tax reserves (accruals) should be segregated as a separate account.  Federal income taxes should always be listed as a current liability.  In addition, a breakdown should be made available as to what part of the reserve for taxes applies to the income taxes accrued on the earnings for the year just completed, and what part of the reserve represents assessments or reserves for prior years' taxes.  If a balance sheet does not show a liability for taxes and a profit is claimed, the company may be understating its current debt.

            (ii)   Due Officers, Stock holders1 etc.  These accounts should be shown separately.  The Price/Cost Analyst must keep in mind that if anything happens, the officers and stockholders of the business usually are in a position to get their money first. 

                    (iii)  Due Affiliated Companies.  These accounts should be shown separately.  If there is only one affiliated company, the name of the company should be shown as due "name of the company."

                    (iv)  Dividends Unpaid.  This account is also an accrued liability and should be shown separately if possible. Dividends declared and payable on a given date are a liability of the corporation and should be shown as a current liability.

                    (v)  Funded Debt (Current).  Serial bonds, notes on mortgage installments, mortgages, and other funded debts due and payable within one year are current liabilities.  The amount which is current should be separated and included in current liabilities.

    2.  Long Term Liabilities.  Long term liabilities are items that mature in excess of one year from the balance sheet date. Normally, items in this area are retired in annual installments. The items most often appearing in this category are mortgage loans, usually secured by the real estate itself, bonds, or other long term notes payable.

        a.  Funded Debt.  Serial bonds, notes on mortgage installments, mortgages, and other funded debts due after one year are included in long term liabilities.  These debts should describe as definitely as possible the kind of bond or mortgage involved, the interest rates, the schedule of requirement payments and in the case of bonds, a notation of facts about any default in principal, interest, sinking fund or redemption provisions with respect to any issue of securities.  Bonds are a means of borrowing long term funds for large and well established companies.  When a company is big enough and financially sound, it will sometimes be able to borrow money on a long term unsecured basis.  When this occurs, the unsecured deferred notes are called debentures.

        b.  Miscellaneous Deferred Liabilities.  Reserves which offset assets, as reserves for depreciation and bad debts, should be deducted from the assets leaving the net asset value for comparison figures.  These reserves should never be shown as deferred liabilities.  However, if there is a Reserve for Contingencies, this account should be classified as a deferred liability on the assumption that the reserve is set up with no particular asset in mind.  Although the reserve might appear to be a part of net worth, the fact that the reserve has been classified as such, rather than a surplus, indicates that management may have some possible loss in mind when segregating it.  If there should be such reserves as Reserve for Insurances, this account should be classified as a deferred liability.

                c.  A deferred credit may indicate that a business has received unearned revenue from customers on work yet to be completed.  Since the completed work is still owed to the customer, the unearned revenue continues to be carried as a liability until the product is completed and delivered, or the unearned revenue is returned to the customer. 

C.  Capital Accounts:

     1.  Definitions.  On corporate balance sheets, net worth may be broken down into the following categories:

        a.  Capital stock represents all issued or unissued shares of common or preferred stock.  Usually preferred shareholders are entitled to priority over common stockholders if a company liquidates.

                b.  Paid in or capital surplus represents money or other assets contributed to the business, but for which no stock or owners' rights have been issued.  This usually occurs from stockholders paying more than par value for the stock.

        c.  Earned surplus is the amount of earnings retained in the corporation and not disbursed as dividends.  When a corporation shows a net worth that has as its components capital stock and retained earnings, capital stock represents shares of equity issued to owners.  Retained earnings are the amount of corporate profits permitted to remain in the business by design of the officers. Analysts view a sizable amount of retained earnings as significant. It shows a business is profitable and successful if it recognizes the need for net worth growth as the company progresses.

        d.  Net worth represents the owners' share of the assets of the business.  It is the difference between total assets and total liabilities.  Total assets minus Total liabilities equals net worth or owner's equity.  If liquidation occurs, assets are sold off to pay creditors and the owners receive whatever remains.  This is why equity sometimes is referred to as "risk capital." 

    2.  Net Worth.

        a.  Capital.  If the statement is that of a partnership, the investment of the partners should be shown separately, as “Investment - John Doe”, “Investment - William Smith”, etc.  If the statement is that of a proprietorship, the investment of the owner should be shown as “Capital - Name of the owner”.  If the statement is that of a corporation, preferred stock, common stock, and surplus should be shown separately.  When payments are received on preferred stock subscriptions or common stock subscriptions, the amounts received for full shares to be issued subsequently should be included with the preferred or common stock.  Where a corporation has issued more than one class of either preferred or common stock, each class issued should be shown separately.  In addition, where the capital stock of a corporation includes preferred stock, the latter's characteristics will largely affect both its position and that of the common.  In listing preferred stock on the balance sheet, the notes to the financial statement should disclose information regarding any preference rights as required in all financial statements filed with the Securities Exchange Commission. 

             (i)  If callable, the date or dates and the amount per share and in total which shares are callable shall be stated.

            (ii)  Arrears in cumulative dividends per share and in total for each class of shares shall be stated.

            (iii)  Preference of involuntary liquidation, if other than the par or stated value, shall be shown.  When the excess involved is significant there shall be shown (1) the difference between the aggregated par or stated value; (2) a statement that this difference, plus any arrears in dividends, exceeds the sum of the par or stated value of the junior capital share and the surplus, if such is the case, and (3) a statement as to the existence, or absence, or any restrictions upon surplus growing out of the fact that upon involuntary liquidation the preference of the preferred shares exceeds its par or stated value.

        b.  Surplus.  Generally speaking, surplus is of two major kinds, earned and capital.  Earned surplus arises out of undistributed earnings and is the balance of net profits, income and gains of a corporation from the date of incorporation (or from the date when a deficit was absorbed by a charge against the capital surplus created by a reduction of the par or stated value of the capital stock or otherwise), after deducting losses and distributions to stockholders and transfers to capital stock accounts, when made out of such surplus.  Capital surplus arises from all other sources, such as (i) accounts paid in by stockholders in excess of par or stated value of capital stock; (ii) donations of capital stock; (iii) write-up of assets; (iv) reorganization of recapitalization; (v) profit on sale of the company's own stock, etc.  It is ordinarily assumed that the total amount of earned surplus is freely available for dividends.  Where surplus is restricted for a specific purpose such as plant expansion, contingencies, redemption of funded debt, or additions to working capital, the amounts so designated should be listed separately as surplus reserves.  The factors which account for the change in the amount of surplus usually are the things which show what the business is doing, whether or not it is making progress.  If the profits, dividends, etc., are known, a reconcilement should be made of the change in the surplus accounts, as compared with the figures of the previous year.  This is important, as appreciation of the assets or large dividends paid during the year may be detected; this otherwise might escape notice.

     3.  Reconciling the Net Worth.

                a.  The net worth of a company represents the margin of safety or protection to a company's creditors; therefore, the DCMA Analyst, on recommending financial capability is always concerned about the changes that take place in net worth from year to year. 

        b.  It must be remembered that the balance sheet portion of a financial statement is only the cut-off point in the operations of business and is only indicative of the company’s position as of that date.  Between the dates of two balance sheets, many changes can take place in the figures, and it is only by means of the profit and loss statement and the net worth reconcilement that these changes can adequately be explained.  If a company wished to window-dress its balance sheet to cover up a loss, it could arbitrarily write up its assets in excess of the loss to increase net worth.  However, in comparing the balance sheet with a previous balance sheet, without the operating statement and reconcilement of the net worth to explain the changes, it would be a normal assumption to believe that the increase in net worth was due to profits earned and retained for the period ended.  The point to remember is that financial statements accepted at face value could be  misleading and may not necessarily show the true financial position of the company. Therefore, the analyst must determine whether the information furnished is sufficiently complete and adequate for analysis before attempting to make an analysis, inasmuch as the results of such analysis could be misleading and inadequate to serve as the basis for a recommendation.

            4.  Recognizing Undercapitalization.

It is also important in financial capability analysis to be able to recognize when a concern is undercapitalized, a condition best reflected by a firm's inability to meet its debt at maturity.  When this condition exists the financial statements usually show  (a) Short Working Capital, (b) Heavy Debt in Relation to Working Capital1 and (c) Rapid Capital Turnover. 


SECTION VI - AREAS OF ANALYSIS 

A.  Working Capital Analysis:  The offeror may have adequate financial strength, but sometimes this is not the case.  If not, the Price/Cost Analyst must determine the amount of working capital required for the prospective contractor to finance current production backlog and the potential contract. 

    1.  Working capital represents the funds available to finance current business operations.  This figure is important, as it is used to determine how much excess cash a business has to fund current expenses.  Working capital is the difference between current assets and current liabilities.  Since a company's resources to pay its current debt come partly from current assets, a business with a comfortable margin should be able to pay its bills and operate successfully.  How much working capital is enough depends on the proportion of current assets to current liabilities rather than on the dollar amount of working capital.

    2.  Determine Working Capital Required.  Additional financing may be needed to expand working capital or facilities.  Some of the factors which determine the amount of working capital required are: 

                a.  Size and type of Contract.  The size of the proposed contract may require expanded working capital, if it is significantly larger than the offeror's general production backlog.  The type of contract may or may not have interim financing and the contractor will need enough resources to operate and perform the contract. 

                b.  Length of Production Period before Shipment.  This is a key factor that determines the amount to be tied up in inventory and work-in-process at one time.  An item which can be assembled simply, or can be produced quickly, will result in investment being minimal. Therefore, only a small amount of funds will be tied up in work-in-process or finished inventory.  If the production period is long, funds will be tied up for a long period of time.  (The above statements are made without giving consideration to progress payments or other means of financing inventories.)

                c.  Schedule of Deliveries.  A contract calling for delivery over a short period will cause inventory and receivables to build up rapidly.  This would mean a larger investment than for a contract which permits a slower delivery rate.  Allowing shipment in small lots keeps down the investment in finished goods waiting to be shipped.

                d.  Raw Material Stocks.  If the raw materials and components used are plentiful and  easy to obtain, a relatively small in vestment is needed.  However, if the stock must be bought in large quantities, working capital needs are increased.

        B.  Bank Restrictions on Debts:  It is important that the  DCMA Analyst determine the terms and conditions of the bank loans.  A long term debt may become a demand note according to the terms of the bank loan.  If the contractor is required to maintain a prescribed ratio of net worth to liabilities and the ratio falls below that prescribed in the loan terms, then the bank has the right to convert this long term debt into a demand note.  The bank could also have a requirement that the contractor maintain a minimum working capital.  If the working capital falls below the prescribed minimum the bank could convert the long term note into a demand note.  Sometimes contractors may be forced into a Chapter XI situation (arrangement or reorganization with either the debtor or a referee in possession) because the bank freezes the company’s cash when it goes below the minimum working capital requirements.

C.  Secured Loans and Their Terms:  A typical secured loan issued by a bank reads as follows:  In accordance with the "Uniform Commercial Code,"

            1.  All accounts receivable existing as of this date, together with any and all such accounts receivables hereinafter acquired and all proceeds thereof.

    2.  Any and all items of inventory now existing or hereafter acquired. 

    3.  All machinery and equipment as delineated on the schedule attached hereto, together with all and similar machinery and equipment hereinafter acquired or replacements thereof and all accessories now or hereafter affixed or to be used by debtor.

    4.  All furniture and fixtures as delineated on the attached schedule together with all and similar collateral hereafter acquired or replacements thereof and all accessories, party and similar items now or hereafter affixed hereto. 

When this clause is in effect and the contractor has progress payments, problems can occur since, in accordance with the progress payment clause, the Government has title to inventory. If a contractor has such a secured loan, then the Government and the bank both have title to the same inventory. 

Thus, when a secured loan is found, the DCMA Analyst should assure that before the Government makes progress payment to a secured contractor where the bank has inventory as part of the security, the bank sign a release (Uniform Commercial Code Form UCC-3) for the progress payment inventory and/or a Subordination Agreement which will subordinate the bank's right to inventory on which the Government has made progress payments.  This type of information and appropriate recommended procedures should be entered in Section VI of the SF 1407. 

D.  Payroll Tax Liability:  A company is required to periodically deposit employees withholding and social security taxes with a bank. A review of the balance sheet may disclose a disproportionately large liability for payroll taxes.  This is a red flag for the Price/Cost Analyst.  It generally indicates that the contractor is delinquent in paying withholding taxes and therefore is probably running short of funds. 

E.  Offeror in Bankruptcy:  When it appears that the potential contractor is almost, or is, in some stage of bankruptcy, you should contact the Bankruptcy Court to determine if bankruptcy has been filed.  The offeror or creditors may be filing for a Chapter VII straight bankruptcy, a Chapter XI plan for credit arrangements, or a reorganization with either the debtor or a referee in possession.  If Chapter XI bankruptcy is in process, the Analyst will have to be particularly astute in analyzing the potential contractor's ability to financially perform the proposed contract.  Bankruptcy under Chapter VII and Chapter XI should be noted in Section VI of the SF 14O7 and fully explained. 

F.  Cash Flow Projection:

If your analysis shows only minimum working capital is available, the offeror should be contacted and advised of the situation.  Ask the offeror whether or not additional financing  has been arranged for, can be obtained.  If the additional funds can be acquired, ask the offeror to promptly forward appropriate evidence regarding the additional financial resources available for financing the proposed contract.  Request a cash flow projection be furnished for review and evaluation.

The potential contractor, if a small business,  may not know how to develop a cash flow projection.  Therefore, the following guidance should be given to the offeror to assist in the development of the cash flow projections. The cash flow projection, or cash budget, shows the effect production and sales plans have on the cash position of the company and is generally developed by monthly periods.

The cash budget is not tied to expected profit or loss; it merely forecasts the fluctuations in the company's bank account.  Following are several key steps in its preparation:

    1.  A schedule of production and shipments should be prepared and broken down by months.  This schedule is the heart of the company's planning.  All of the company's production, commercial and Government, should be included.

    2.  The schedule of shipments is translated into a schedule of cash receipts.  The time lag between invoicing and receipt should be taken into account.  In many cases where cash flow forecasting is needed, Government contract terms provide for progress payments. Receipt of progress payments should be provided for in the cash flow statement.

    3.  Receipts from other sources, such as sale of property, stock, or bonds are added to the receipts from collections of accounts receivable.  The result is the total cash receipts expected during the period involved.

    4.  A schedule of planned purchases of raw material, sub-assemblies, components, equipment, and facilities is made. This is then translated into a schedule of cash on delivery and accounts payable to suppliers.

    5.  Using the production schedule as a basis, cash outlay is figured for the main production expenses, including wages, factory overhead, and selling and administrative expenses.  This does not include the noncash expense of depreciation or amortization.

    6.  Income tax payments (including withholding) should be scheduled at the time they accrue for payment.

    7.  Any other expected payments, such as dividends or loan repayments, are entered next.  When withdrawals or dividends exceed profits, they diminish net worth.

            8.  For each period the total of all estimated payments is subtracted from the total of all estimated receipts.  This is done for each selected interval.  The result is the net increase or decrease in funds for the period.  Adjustments are made for cash on hand at the beginning of the period and for the minimum working balance of funds needed for the period.  The cash available or needed by the end of the month is the offeror's cash position at the end of the month.

G.  Possible Problem Areas

    1.  Accounts are not classified according to generally accepted accounting principles. 

    2.  Financial statements are on a hybrid cash and accrual basis.  They may show accounts receivable but not accounts payable. The offeror has not accrued the liabilities.

    3.  Errors may also be found where the offeror erroneously adds ending inventory to cost of goods manufactured in the operating statement, instead of subtracting it.

    4.  Progress payments are sometimes booked as a sale instead of treated as reduction of inventory or as a liability.

    5.  Error of omission occurs when liability for income taxes are omitted.

    6.  Unrealistic values assigned to fixed assets upon commencing business.  This results in overstated net worth.

    7.  Recording accounts or notes receivable from officers of the company when the officers do not intend to repay the advances or loans.

    8.  Restricted cash (escrow account) included with cash as one figure on the balance sheet.

    9.  Footnotes are missing for the financial statement.  The footnotes may be withheld because they contain adverse information pertaining to debts, contingent liabilities1 etc.

     10.  Investment in discontinued operations may not be written off.

    11.  Ratio of gross profit to sales appears unusual when it is compared to previous years.  This could be because of inflated inventory.

H.  Recording of Financial Data:  The results of the analysis made of the company's balance sheet reflecting the financial position and profit and loss statement for the period, showing net sales and net profit, should be recorded to enable comparisons to be made with previous periods.  Such recordings are important to the Analyst in determining trends.  If a substantial downward trend is indicated, appropriate action must be taken to determine the cause, the prospects of recovery, and the effect on contract performance.

 

SECTION VII - WORKING CAPITAL 

A.  Reconciling Working Capital:

            1.  When a DCMA Analyst is determining financial capability, interest should center on the current assets and current liabilities of the company.  The increases or decreases in "working capital or net current assets" do not necessarily follow the trend of profits or losses.  It is not unusual for a company to experience a period of profitable operations and at the same time show no improvement in its working capital position.  On the other hand, the company could show losses from operations without affecting its working capital.

    2.  In reconciling changes in working capital, there are two points of primary interest.  They are the cause and effect. The effect is determined by comparison of the current working capital, with that of a previous date.  The increase or decrease is the effect of a change.  Since the effect is found in the working capital items themselves, it is necessary to look to the other elements of the financial statement for the cause.  The factors which cause changes in working capital are:

            Changes Which Cause Increases:

Profits

Depreciation*

Sale of Fixed and Other Assets

Increases in Long Term Liabilities

Increases in Capital

     Changes Which Cause Decreases:

                Losses

                        Dividends or Drawings

                        Increases in Fixed and Other Assets

                        Decreases in Long Term Liabilities

 *  Depreciation is an operating charge against the profits. However, the fact that the charge offsets other assets and does not affect the current assets necessitates its being added back to profits in reconciling working capital. 

B.  How the Offeror Can Indirectly Improve Financial Condition:  The offeror may want to use subordination agreements, guarantee agreements, financial position, deferred payments, advance payments, etc., to improve the firm's financial position to satisfy the Government’s concerns.  When this occurs, inform the customer and/or ACO.

    1.  Use of Subordination Agreement.  The use of Subordination Agreements is appropriate to protect the Government’s interest when working capital has been provided by way of loans during contract performance.  Specifically,  the use of Subordination Agreements support the rights of the Government by certain clauses that may be in the contract that give title. There is a basic form for accomplishing this; it is DCMA Form 1619.  Modifications to the form must be coordinated with legal counsel since this is a legal document.

When the offeror's latest current interim balance sheet shows current monthly payments are being made on long-term loans, and even short-term loans in some cases. Subordination agreements are to be put into place as soon as possible on new awards,  the need for these should be brought out in the pre-award phase and drafted accordingly. Work with the contractor to ensure the holders of the loans (creditors) are willing to execute a formal Subordination Agreement to the rights of the Government.  If the creditors are willing to enter into a Subordination Agreement, the offeror will request each creditor to execute the Subordination Agreement in 4 copies and promptly return all copies to the DCMA Analyst in order to meet the time allowed for performing the PAS.

Basically, Subordination Agreements should be obtained when funds are obtained and put into the business under a loan agreement, whether pre or post award.  It is very important to make the Government’s rights known and protected as soon as possible.  If the offeror finds sources ( lenders, or additional lenders)  willing to loan additional funds after contract award, the procedures to be followed for requesting, executing, and returning Subordination Agreement forms to the DCMA Analyst, through the Administrative Contracting Officer (ACO).   It is still important and not too late to do this during post-award, should loans and creditor/lenders be identified subsequently after award that are not already covered by a Subordination Agreement. This could occur in cases where new lenders loan to the contractor right after award and were not previously identified to the Government, or, later during contract performance the contractor obtains loans/new creditors to continue work.  Once a new lender/credit source has been identified that is not covered, has no subordination agreement in place, work with the ACO to obtain one.  DCMA, whether it is the analyst or the ACO will have to determine if the credit source has authority to enter into such agreement ; that the agreement will actually cover the contracting unit which is liable to perform/complete the work.  Seek legal advice when not certain as to the business structure and relationship of the business unit actually performing the contract work. 

    2.   Use of Guaranty Agreement.  The DCMA Analyst may suggest to the offeror (and advise the customer) the use of a Guaranty Agreement as a satisfactory way for assuring financial capability to perform the proposed contract (preaward) or the existing contract (for contract completions in postaward). Coordinate this effort with the Administrative Contracting Officer (ACO) or Corporate ACO (CACO) cognizant over the Contractor when putting a Guaranty into place.  Particular caution is encouraged with Guaranty Agreements:  First of all, understand the Guarantor's relationship to the contractor or contracting entity, be sure the legal structure and relationship is understood . Then, the analyst should determine that the Guarantor is financially capable of supporting the commitments made in the agreement.  In short, in many cases,  a financial check must be made of the Guarantor.  In addition, guaranty agreements done by a Guarantor using their forms and language instead of DCMA Form 1620 must be reviewed by DCMA Legal Counsel prior to execution.  There will be times the contractor will want to use their own Guaranty Agreement form or language and it may be acceptable but must be determined by DCMA Legal Counsel before accepting/ executing. Also, the form can be modified with legal guidance to make it work for an individual guarantee.

    3.  Offeror Obtains Deferred Payment Arrangements for Material, etc.  The offeror may get financial relief by requesting a supplier to defer payments until after the contract is completed. This should be part of the offeror's financial plan for demonstrating financial capability to perform.  If the future supplier is willing to defer payments until after contract completion, the offeror should arrange with the supplier to promptly furnish the analyst an appropriate letter deferring payments.  The letter should be specific regarding the amount and the duration of such deferred payments.  The letter should be signed by an authorized representative of the supplier.  The DCMA Analyst should also determine that deferred payment does not adversely effect the financial viability of the supplier.

C. Obtaining Additional Fixed Assets:  If the potential contract will require the offeror to acquire additional fixed assets, increased working capital will be required for the down payment and monthly or quarterly payments.  When the equipment is to be obtained by lease, working capital also will be needed.  In this area, coordinate the need for the production equipment with the preaward monitor to assure the proposed equipment purchase or lease is required to perform the contract. 

D.  Progress Payments:  There have been indications that some contractors are improperly accounting for progress payments as sales, instead of treating them as liabilities.  This has the effect of inflating working capital, unless a contra-asset account is offset against work-in-progress.  The preferred accounting treatment is to debit a current asset account (e.g., Progress Payments Receivable) and credit a current liability account (e.g., Unliquidated Progress Payments).

     1.  While the exact point at which a sale occurs might involve complicated legal question most accountants treat the point of sale as the point at which delivery takes place.  Payments received in advance from customers give rise to a liability for the delivery of goods or services.  The advance payments are originally recorded as liabilities and are then transferred from the liability account to the revenue account when delivered.  Accounting Research Bulletin No. 43 specifically includes among current liabilities, advance payments for the delivery of goods or the performance of services in the normal course of operations.  This treatment is correct for two reasons:  (i)  the advance is a current financing transaction rather than revenue producing, and (ii) the obligation to provide goods and services is generally a part of current operations.

     2.  An acceptable (although not preferable) alternative method of accounting for progress payments involves the use of a contra-asset account.  This account is set up to record a subtraction from a related asset account which is reporting a positive balance.  For example, a contractor who debits Progress Payments Receivable and credits Sales at the time of a progress payment would then be required to debit Cost of Sales and credit a contra-asset account (e.g., Progress Payments - US Government).  The latter should be shown on the balance sheet as a deduction from the current asset account, Work-In-Progress.

     3.   Under either the preferable or alternative treatment, the computation of working capital would yield identical results. There are situations where revenue may be recognized at the time of production.  However, this is more applicable to long-term construction contracts where failure to accrue revenue during the life of the contract would lead to considerable erratic fluctuations in reported revenues from one year to the next.  For example, the "percentage of completion" method might be appropriate when an aircraft carrier is under construction.

     4.  FAR 32.0, "Contract Financing," and DCAAM 7640.1, "DCAA Contract Audit Manual" stress that contractors' accounting systems and controls must be adequate for the proper administration of progress payments.  In order to comply with the above procedures and regulations, DCAA is often requested to review contractors' accounting systems to ensure that they are adequate for the proper administration of progress payments.  It is DCMA's understanding, however, that auditors concentrate more on contractors' systems for cost accumulation rather than on how progress payments are treated on the balance sheet.

     5.  The DCMA Analyst should thoroughly review the financial statements of contractors who are receiving progress payments and who possess marginal financial capabilities.  By identifying what accounts are charged at the time of progress payments, the analyst will be able to perform a more accurate evaluation of the contractor's working capital and determine if it is adequate to finance the current production backlog as well as the potential contract.  If problems appear to exist, then DCAA may be requested to provide additional input relative to the contractor's specific treatment of progress  payments.

     6.  The DCMA Analyst may also be able to uncover potential problems by comparing the unliquidated progress payment amount on a contractor's balance sheet to the contractor's total unliquidated progress payment amount indicated in the MOCAS reports.  A significant difference could indicate that progress payments are not being properly accounted for.  If a contractor's sales volume is known to be small, financial statements reporting significant sales and work-in-progress figures could be another indication of improper accounting treatment of progress payments.
 
SECTION VIII - COMPLETING THE PREAWARD FINANCIAL SURVEY 

When financial information, including cash flow projection data (when applicable), has been reviewed, analyzed, and evaluated, the DCMA Analyst should prepare a report with rationale to support the conclusion for an affirmative or negative financial recommendation. 

A.  Support Your Recommendation:  The report format and rationale to support your conclusions and recommendation should be prepared in accordance with SF 1407.  It may be necessary for the DCMA Analyst to adjust the offeror's balance sheet data.  Place an asterisk by the total as indicated below and explain your adjustments. 

       For example:

                     Current Assets        $ ___________________*

                     Current Liabilities    $ ___________________*

                     Working Capital        $ ___________________*

                     Net Worth                    $ ___________________** 

*   Changes affecting working capital (list of accounts and their amounts)

**  Changes affecting net worth (list of account and their amounts)

B.     Completing Section I of SF 1407:  Completion of Section I of SF 1407 is your most important contribution to the PAS.  Your narrative should be concise, but thorough. Check with PAS monitor for current forms. 

An example:

In response to Solicitation No.  ________________________,

(Contractor]_________________ has submitted a bid of $ __________

to provide _____________________
      (quantity, product or service,

customer delivery schedule, etc.).  The working capital required for this effort is estimated at $ ___________________ based upon   (state your basis for estimate of working capital).

 

Financial statements submitted by the offeror show working capital of

$ _______________ and a net worth of $ __________.   Their current ratio (current assets/current liabilities) of ___________ compares favorably (or unfavorably) with an industry median of____________, as does the quick ratio (current assets/less inventory/current liabilities] of _______ ______________ with the industry figure of    __________. These ratios indicate an adequate (inadequate) liquidity position and the ability (inability) to keep pace with current operating expenses.  Their debt ratio (total liability/net worth) of_________ compares favorably (unfavorably) with the industry median of______________, indicating that the company carries a moderate (inordinate, light1 etc.) amount of debt. 

Profitability and sales ratios show upward (downward] trend over the last three accounting periods indicating __________

        (State any other considerations or analysis used to develop your recommendation, such as percentage of sales estimate of external funds required, cash flow statements additional financing available, other financial ratios, etc.)

________________________________________________. 

Given an overall good (marginal] financial condition, adequate (inadequate) liquidity, and sufficient (in sufficient) working capital to support the proposed contract (as well as existing backlog), the Analyst considers the offeror financially responsible and an AWARD/NO AWARD is recommended. 

If another method of financing is to be used, such as subordination, deferred payments, or guaranty agreements, the narrative should be amended accordingly.  The narrative may be attached separately by referencing Section I.  Complete all blocks of SF 1407 with the appropriate comments, based on supporting documents, and provide other information considered pertinent to the case and important to the PAS monitor.

C.  Supervisory Review of Preaward Surveys:  In order to assure that good financial capability analysis preaward surveys are being made, the cases should be reviewed by supervisory personnel prior to submitting them to the PAS Monitor. The following type cases should receive priority for review:

            1.  Negative case. 

    2.  Case on a new offeror.

            3.  Case where only minimum working capital is indicated.

If the DCMA  financial analyst is new to the job, the review should  be done with the support of a  senior analyst, with  advisement and review.  . If there are no senior analysts/ personnel with this experience and capability within the CMO, then the CMO supervisor should seek assistance through the DCMA District .

D.  Maintain the Financial File:  File all supporting data and related documentation in the financial file of the proposed offeror.  This provides comparative data for future reference and assists in performing subsequent financial capability analysis preaward surveys. 

 

SECTION IX - FINANCIAL PREAWARD ON A PRIOR OFFEROR 

This section discusses how to update the offeror’s existing financial data. 

A.  Updating Financial Data:  Since there is already a historical file of financial information on the prior offeror, the PAS is performed in a slightly different manner.

            1.  Review Offeror's File.  The prior offeror's financial file will be reviewed to determine if the information is current.  The Price/Cost Analyst should perform all the procedures required of a PAS for the new offeror.

    2.  Financial Data May Be Current.  If the financial information is current, a copy of SF 1407 issued under a prior survey request may be submitted provided the information is still valid.  In such a case, a new statement will be included that is applicable to the proposed contract.

    3.  Financial Data Not Current.  If the information is not current, it must be updated.  The Price/Cost Analyst should contact the offeror and request that the firm furnish the required financial information necessary for review, analysis, and evaluation.  If necessary, remind the representative that the offeror is responsible for establishing financial capability to perform the proposed contract.

    4.  Analyzing New Financial Data.   Upon receipt of the prior offeror's current financial information, it should be reviewed, analyzed, and evaluated.  All blocks of the SF 1407 must be completed.  Adequate comments from the supporting information are to be provided.  A report with rationale to support conclusions and the recommendation in Section I of SF 1407 is to be prepared in the same manner as for any other preaward survey.

B.  Depth of Analysis:  The scope and depth of financial analysis required to perform a preaward case of a prior offeror satisfactorily is a matter of judgment.  Generally, it is directly related to the strength and financial condition of the offeror, the dollar amount of production commitments, and the dollar amount of the proposed contract.  The DCMA Analyst can not expect to perform an in-depth analysis in every case because the period of time precludes it and the financial strength may be sound enough for an affirmative recommendation.  However, analysis must be in sufficient depth to support conclusions and a recommendation.  The  analyst should verify that all necessary evaluations are complete and the data is current.  If additional financial information (financial statements, etc.) is necessary for updating the financial information in the file, or if new financial information is necessary, i.e., a cash flow statement or cash flow projection/forecast, it should be requested.

SECTION X - POSTAWARD FINANCIAL SURVEILLANCE 

The DCMA Analyst is responsible for continuous or follow-up financial analysis reviews based on risk handling/risk monitoring of the financial condition of the particular contractor.  Postaward monitoring  will be done in accordance with the risk, based on the risk rating designated originally, or if conditions are known to be changing with the contractor.  Closely work with  the ACO as appropriate during the contract performance period, especially where contracts have interim financing arrangements.  To accomplish postaward or follow-up reviews, the contractor's balance sheet, operating statement, and related data should be submitted periodically to the DCMA Analyst.  The analyst will review these statements to determine if the contractor has sufficient funds to complete the existing contract.  (The current updated financial data can also be used to perform a new preaward survey on the contractor.)  The DCMA Analyst will most often work within a CMO team where the ACO is apprised of any known change in  the contractor's financial condition, particularly if adverse financial conditions.  Any DCMA employee who has knowledge of changing conditions should advise the ACO and the analyst. The ACO may request a review be done at any time they feel conditions warrant a review.

A.  Extent of Coverage of the Postaward and Frequency of Performance:  Postaward Financial Monitoring is performed on contractors in the "Contract Administration Report" to the extent that the contractor's financial condition warrants continuous monitoring, (i.e., when the contractor receives Government financing such as progress payments or advance payments).  Financial monitoring is also performed on a contractor whose financial condition was determined to be high risk or marginal or where minimum working capital is available to perform the contract as reflected in the preaward survey. 

B.  Arranging for Submission of Financial Data:  If prior arrangements have not been made for automatic forwarding of the contractor's current financial statements in the frequency that the firm normally prepares them, the DCMA Analyst will request the contractor to furnish its financial statements (balance sheet and operating statement, etc.) on a monthly, quarterly, semiannual, or annual basis, as deemed appropriate. 

C.  Reviewing the Data and Reporting the Results:  The DCMA Analyst will review and evaluate the data in a timely manner.  When necessary, a financial surveillance/monitor report equivalent to “Postaward Financial Surveillance Report") will be prepared and forwarded to the ACO for information and further action as deemed necessary. 

D.  Summary:

            1.  In financial statement analysis, the DCMA Analyst must carefully review all accounts of the financial statement as well as the footnotes provided.  Review footnotes to determine if you understand them.  Determine if the footnotes are reasonable.  A questionable account should be clarified by questioning the company's officers.

    2.  The guidelines for classification of accounts should be followed as closely as the case allows.  The guidelines are intended to provide the maximum uniformity possible, so that comparisons are easier to draw.

 

APPENDIX A - SOME SOURCES OF FINANCIAL DATA

Some of the following site are available for gathering data and are also listed under  the Knowledge Management site


APPENDIX B - FURTHER READINGS

 An academic library serving a business school would have a good selection of  financial evaluation/analysis textbooks and materials.   Check your local libraries, which should have some of these types of books.  Here are some that have been used for reference in the past.  For most recent publications and reference material,  check the Web, use Google or Yahoo search engine for books on Interpreting Financial Statements, Reading, Understanding Financial Statements, Financial Liquidity Ratios, Cash Flow Analysis, etc.

Developments in finance normally appear in journal articles before being discussed in books. (Several universities have journals or information from journals on line.) Such magazines are indexed by the following:

APPENDIX C - FINANCIAL RATIOS

There are many financial ratios that can be calculated.  Some are more useful than others.  You should determine which ratios are the most important in your industry.  Listed here are thirteen ratios that are most often used by financial analysts. Solvency Ratios:  Quick Ratio, Current Ratio, Current Liabilities to Net Worth, Total Liabilities to Net Worth; Fixed Assets to Net Worth; Efficiency Ratios:  Collection Period, Inventory Turnover, Assets to Sales, Sales to Net Working Capital, Accounts Payable to Sales; Profitability Ratios:  Return on Sales, Return on Assets, Return on Equity.

The following is a more complete list of Ratios and synopsis of the information they provide.  Commonly applied ratios used in financial analysis are defined below in seven groups for convenience.  These groupings should not restrict their usage.

A.  Solvency Ratios:  Solvency, or liquidity, ratios are used to measure the financial soundness of a business and how well it can satisfy its obligations.  They are designed to help measure the degree of financial risk that a business faces. "Financial risk," in this context, means the extent to which the business has debt obligations that must be met, regardless of the cash flow.  These ratios are of particular interest to short term creditors.

1.  Absolute Liquidity Ratio  This ratio shows how much of a firm’s current liabilities can be covered by its most liquid assets, cash and marketable securities.  The liquidity ratio measures the extent to which a company or other entity can quickly liquidate assets and cover short-term liabilities, and therefore is of interest to short-term creditors.  Also called cash asset ratio or cash ratio.  Current liabilities are payable within one year.

Absolute Liquidity Ratio = Cash + Marketable Securities
                                              Current Liabilities 

2.  Acid Test Ratio  The Acid Test, or Quick, Ratio differs from the Absolute Liquidity Ratio to the extent that net Accounts Receivable is considered.  It is another way to determine whether a company can make their day-to-day payments. 

            Acid Test Ratio = Quick Ratio =  Cash + Marketable Securities + Accounts Receivable (net)
                                                             Current Liabilities

3.  Current Ratio  This is also called the working capital ratio. Current or trading assets include items that can be converted to cash within one year of normal operations.  They include cash, marketable securities, accounts receivable, as considered in the acid test ratio, while adding the value of inventory.  Although short term creditors may feel more comfortable when the debtor firm has a high current ratio in comparison to its competitors, too high of a current ratio may signify inefficiency, since too much may be tied up in nonproductive assets.  Generally, any value of less than 1 to 1 suggests an over-reliance on inventory or other current assets to pay off short-term debt.  Higher ratios indicate a better buffer between current obligations and a firm's ability to pay them. The quality of current assets is a critical factor in interpreting this analysis.

                        Current Ratio = Current Assets
                                            Current Liabilities

 4. Accounts Payable to Sales Ratio  This ratio measures how a firm pays its creditors in relation to its sales volume - the speed with which a company pays vendors relative to sales.  A low percentage is usually considered healthy.  Numbers higher than typical industry ratios suggest that the company is using suppliers to float operations.

                        Accounts Payable to Sales Ratio = Accounts Payable
                                                                              Net Sales

5.  Accounts Receivable Turnover Ratio  This ratio measures a firm's efficiency in freeing up working capital by providing the rate at which working capital tied up in receivables is converted to cash.  The higher the turnover, or number of times in a given period that receivables are turned into cash, the more liquid are the firm's receivables.  For industry wide comparison, Net Sales is often used.  Some prefer to use Total Credit Sales.  Net Sales is the total of the invoices billed during a given period, less any discounts and returns.  Average Accounts Receivable is the average of the beginning and ending balances for a given period.

Receivables Turnover = Total Credit Sales
                                  Average Receivables Owing 

6. Assets to Sales Ratio This ratio measures the percentage of investment in assets that is required to generate the current annual sales level.  A high percentage may indicate that the firm is not being aggressive enough in its marketing effort, or it is not fully employing its assets.  A low percentage may indicate that the firm is selling more than can be safely covered by its as sets. 

                             Assets to Sales Ratio = Total Assets
                                                                Net Sales

7.  Average Collection Period  This ratio provides the average period required to collect receivables.  It provides an indication of the quality of a firm’s receivables and serves as a measure of the efficiency of its credit department in granting credit and collecting payment.  The ratio may be compared to both the firm's credit terms and the industry average to measure effectiveness.  If credit trans­actions vary, such as a retailer selling both on open credit and installment, this ratio should be calculated for each category.  Discounted notes, which create contingent liabilities, must be added back into receivables.

                             Average Collection Period = 365 (Accounts + Notes Receivable)
                                                                        Annual Net Credit Sales

8.  Collection Index The collection index provides insight similar to that of the average collection period.

                  Collection Index = Collections Made During Period
                                                  Accounts Receivable Owing at Start of Period 

9.  Past Due Index  This index can be useful in trend analysis to indicate whether there is improvement or deterioration in collection policies and procedures.

                 Past Due Index = Total Amount Past Due
                                                Total Sum Uncollected

10.   Bad Debt Loss Index  This index may be calculated on either credit sales or total net sales.  An increase in this index is not necessarily bad, if a more relaxed credit policy results in more sales and profit than losses. 

                         Bad Debt Loss Index (BDLI) = Bad Debt Losses
                                                                      Total Credit Sales

11.  Basic Defense Interval This provides the period of time a firm can cover its cash expenses without additional financing should all revenues cease.

                             Basic Defense Interval (SDI) = 365 (Cash + Receivables + Marketable Securities)
                                                                          Operating Expenses + Interest + Income Taxes

12.  Inventory Turnover Ratio  This ratio provides an indication of the liquidity of inventories.   A low ratio may indicate that too much cash has been invested in inventory. 

                    Inventory Turnover Ratio = Cost of Goods Sold
                                                                  Average Inventory 

13.  Net Sales to Inventory Ratio An annual increase in this ratio is often considered healthy, while a decline may indicate problems.  A low ratio may indicate obsolete inventory, over commitment of investment in inventory, poor purchasing policies, or contingency stockpiling. 

                                      Sales to Inventory Ratio = Net Sales
                                                                           Inventory

B.  Working Capital Ratios:  Gross working capital describes current assets, while net working capital is current assets minus current liabilities. Inadequate working capital can be corrected by lowering sales or increasing assets by retaining earnings or selling stock. 

1.  Cash Available to Finance Operations Ratio This ratio roughly indicates whether there is sufficient cash to finance current operations.  It is similar to the basic defense ratio, except the depreciation is omitted from the denominator, since it is not a cash drain. 

        Cash Available to Finance Operations Ratio = 365 (Cash + Receivables + Marketable Securities)
                                                                                        Operating Expenses - Depreciation + Interest +
                                                                                         Income Taxes 

2.  Current Asset Turnover Ratio  This ratio is useful in identifying trends in the turnover and profitability of current assets.  The ratio is slightly less accurate, if depreciation is included. 

        Current Asset Turnover Ratio = Cost of Good~ Sold + Expenses + Interest + Taxes - Depreciation
                                                                Average Current Assets 

3.  Current Liabilities to Net Worth Ratio This ratio measures the proportion of funds current creditors contribute to operations, or the amounts due creditors within a year as a percentage of the shareholders’ investment.  An increasing ratio indicates decreasing security for creditors.

                        Current Liabilities to Net Worth Ratio = Current Liabilities
                                                                                    Tangible Net Worth

Current Liabilities to Inventory Ratio  This measures the extent to which a firm relies on sales to generate funds to pay current liabilities.

                        Current Debt-to-Inventory = Current Liabilities
                                                                 Inventory
5.  Working Capital Ratio This is another name for the current ratio, a liquidity ratio.  If the ratio is less than one then there is negative working capital.  A high working capital ratio is not always a good thing, it could indicate that there is too much inventory or there is not enough investment of excess cash.

                        Working Capital Ratio= Current Assets
                                                           Current Liabilities

6.  Long Term Liabilities to Working Capital Ratio Normally this ratio should not exceed 100% 

                                  Long Term Liabilities to working Capital Ratio = Long Term Debt
                                                                                                              Net Working Capital

7.  Inventory to Net Working Capital Ratio Overstocking can lead to bankruptcy.  Normally this ratio should not exceed 80%, but should be compared with the industry average.  This ratio is often used in conjunction with the inventory turnover ratio. 

                                   Inventory to Net Working Capital = Inventory
                                                                                       Net Working Capital 

8.  Working Capital Turnover Ratio This ratio indicates whether a firm is over invested in fixed, or slow, assets.  It should be compared with the industry average.  It complements the sales to net working capital ratio.

                 Working Capital Turnover = Net Sales
                                                                  Net Working Capital
9.  Sales to Net Working Capital Ratio This measures the number of times working capital is turned over annually in relation to net sales.  A high turnover rate may indicate excessive sales volume in relation to the investment in the business, or extensive reliance on credit.  This ratio should be used in conjunction with the working capital turnover ratio.

              Sales to Net Working Capital Ratio = Sales
                                                                        Net Working Capital

C.  Leverage Ratios: These ratios indicate proportionate risk to a firm's owners and creditors.  Leverage can increase both earning and losses. 

1.  Debt and Preferred Ratio This ratio measures the extent of financing contributed by creditors and preferred owners.

               Debt and Preferred Ratio= Long Term Debt + Preferred Funds
                                                       Total Capital Employed

2.  Debt Ratio This ratio measures the percentage of total funds supplied by creditors.  Creditors normally prefer a lower ratio, but management may use leverage to produce a higher ratio. 

                           Debt Ratio = Current + Long Term Debt
                                           Total Assets 

3.  Debt to Equity Ratio This ratio provides the relative positions of creditors and owners.

                                    Debt to Equity Ratio = Long Term Debt + Preferred
                                                                   Common Stockholders' Equity

4.  Equity Ratio This ratio shows the share of the firm's capital provided by equity holders. 

                         Equity Ratio = Common Shareholders' Equity
                                           Total Capital Employed

D.   Coverage Ratios: These ratios measure the protection offered creditors and a firms ability to attract new shareholders and arrange its debt advantageously. 

1.  Cash Flow to Liabilities Ratio This ratio is used to compare statements with a firm, rather than industry, because of varying depreciation practices. Ideally, liquidity would increase as due dates for debt maturity approach. 

                        Cash Flow to Liabilities Ratio = Net Income + Depreciation
                                                                        Total Liabilities 

2.  Current Assets to Total Liabilities Ratio This ratio measures protection for both short and long term liabilities.  A ratio in excess of 1OO% indicates that long term creditors may be paid out of working capital if the firm is liquidated. 

                         Current Assets to Total Liabilities Ratio = Current Assets
                                                                                         Current + Long Term Debt 

3.  Dividend Payout Ratio This ratio is the percentage of earnings received by shareholders during each period. 

                        Payout Ratio = Dividends per Share
                                           Earnings per Share
4.  Fixed Assets to Net Worth Ratio Disproportionate investment in illiquid fixed assets decreases the amount of funds available for daily operations and can leave a firm vulnerable to unexpected hazards and adverse changes in the business climate.

        Fixed Assets to Net Worth Ratio = Fixed Assets (net) - Intangibles
                                                                    Tangible Net Worth

5.  Shareholder's Equity Ratio A low ratio of equity to assets may precede difficulty in meeting interest charges and debt obligations.

                                     Equity Ratio = Shareholders' Equity
                                                               Total Assets 

6.  Tangible Net Worth to Total Debt Ratio This ratio measures the proportion between the shareholders' capital and that contributed by creditors.  It is the inverse of the debt ratio. 

                              Tangible Net Worth to Total Debt Ratio = Tangible Net Worth
                                                                                             Total Debt 

7.  Times Interest Earned Ratio The margin between income and interest payments is considered a good indication of a firm's ability to meet interest payments. 

                            Times Interest Earned Ratio =  Earnings Before Interest and Taxes
                                                                          Interest Expense

8.  Total Liabilities to Net Worth  This ratio relates debt to equity.  The higher this ratio, the less protection for creditors.  Intangible assets, such as good will or capitalized research and development, should be excluded from net worth. 

                        Total Liabilities to Net Worth Ratio = Current + Deferred Debt
                                                                                Tangible Net Worth

E.   Profitability Ratios: These ratios provide the answer to management's overall effectiveness ranked by returns generated on sales and investments. 
    Gross profit is the difference between net sales and the cost of goods sold, which is the sum of the expenses required to manufacture, purchase, or service customers.
    Net profit after taxes is the basic measure of a firm's operating success.  It is gross profit less all expenses directly applicable to the firms operations, including income taxes.  Any surplus (profit) can be added to retained earnings or distributed to shareholders as dividends.  When expenses exceed net sales and a loss occurs, this loss is charged against net worth as a reduction to the equity account. 

1.  Capital Turn Over Ratio  This ratio indicates whether investment is adequately proportionate to sales and whether a potential credit problem or management problem exists.  A high ratio may indicate overtrading or undercapitalization, while a low ratio may indicate over-capitalization. 

                        Gross Tangible Fixed Assets – Land Ratio = Net Sales
                                                                                              Tangible Net Worth

2.  Earnings per Share  It should be noted that all significant aspects of a firm's performance cannot be reduced to a single figure as represented by this highly publicized financial ratio. 

                        Earnings Per Share (EPS) = Earnings After Taxes - Preferred Dividends
                                                                   Average Number of Common Shares Outstanding

3.  Earning Power  Earning power is increased by heavier trading on assets, by decreasing cost to lower the break even point, or by increasing sales faster than the accompanying rise in costs. Usually, sales is the key. 

                        Earning Power = Net Sales        x            Earnings After Taxes
                                              Tangible Assets                   Net Sales 

4.  Gross Profit on Net Sales Ratio  This ratio provides the average mark up, or margin, on goods sold.  It can help identify trends in a firm's credit policy, markups, purchasing, and general merchandising.  It may vary widely among firms in the same industry, according to sales, location, size, and competition. 

                         Gross Margin Ratio = Gross Margin
                                                        Net Sales

                  Gross Profit Rate = (Net Sales) - (Cost of Goods Sold)
                                                                    Net Sales

5.  Management Rate of Return  This rate quantifies the efficient use of assets compared with a target rate of return.

                   Rate of Return = Operating Income
                                                Fixed Assets + Net Working Capital 

6.  Maintenance and Repairs to Net Sales Ratio  This is an example of an expense ratio by an expenditure category that might be important in a particular industry. 

                         Sum Spent on Repairs per Dollar of Sales = Maintenance and Repair Costs
                                                                                              Net Sales

7.  Net Operating Profit Ratio  When there are significant financial charges, this ratio is preferable to the return on assets ratio.  Net profit to net worth is influenced by the method of financing. 

                             Net Operating Profit Ratio = Earnings Before Interest and Taxes
                                                                        Tangible Net Worth 

8.  Net Profit to Tangible Net Worth  This ratio measures management's ability to realize an adequate return on the capital invested.  It is often compared with an industry average. 

                         Net Profit Rate = Earnings After Taxes
                                               Tangible Net Worth

9.  Net Profits to Net Working Capital  Working capital provides the cushion to carry inventories and receivables and finance ordinary business operations. 

                        Net Profits to Net Working Capital = Earnings After Taxes
                                                                               Net Working Capital

10.  Operating Expenses Ratio  This ratio shows management's ability to adjust expense items to changing sales.  Trend analysis identifies any problem category. The higher this ratio the more sales are being absorbed by expenses.  Total operating expenses include cost of goods sold, selling, administrative, and general expenses.

                Operating Expenses Ratio = Total Operating Expenses
                                                                  Net Sales 

11.  Operating Ratio  This ratio measures the profitability of normal business operations.  It excludes other revenue, or loses, extraordinary items, interest on long term debt, and income taxes. It is usually compared with industry averages. 

                                    Operating Ratio = Operating Income
                                                            Net Sales

12.  Price Earnings Ratio  This ratio is used to compare alternate investment opportunities.  It may be interpreted as the value placed on a particular firm's earnings.

                                    Price Earnings Ratio = Market Price Per Share of Common Stock                                                                             Earnings Per Share

13.  Rate of Return on Common Shareholders' Equity  This ratio is based on book value and is used for comparison with similar firms within the same industry. 

                        Rate of Return = (Earnings After Taxes) - (Preferred Stock Dividends)
                                             (Tangible Net Worth)- (Par Value of Preferred Stock)

14.  Rate of Return on Total Assets This measures management's ability to earn a return on the firm's assets without regard to variations in the method of financing. 

                        Rate of Return on Total Assets = (Earnings After Taxes) + (Interest Expense)
                                                                         (Average Total Assets during the Year)

15.  Return on Sales  This rate is usually compared with the industry average.  The higher the rate, the better the firm is able to survive a downturn.  If the rate is low, a high turnover of inventory is required to obtain an adequate return on investment. Normally this rate is fairly constant over time. 

                        Net Profit Rate = Earnings After Taxes
                                              Net Sales

16.  Turnover of Total Operating Assets Ratio  This ratio tracks over investment in operating assets.  Trend analysis indicates direction of any change. 

                        Turnover of Total Operating Assets = Net Sales
                                                                                Total Operating Assets

APPENDIX D - BANKRUPTCY PREDICTION 

Financial Jeopardy and the Use of the "Z-Score" 

The failure prediction model provides a means to assess a firm's financial health in terms of the probability of future bankruptcy.  This model employs a multiple discriminant analysis of five significant financial ratios to calculate an overall "Z- Score." 

         Z-Score  =1/2a + 1.4b +3.3c + 0.6d +1.0e,  where: 

a = Working Capital to Total Assets = Net Working Capital 

      This ratio measures net liquid assets relative to total capitalization.  Consistent operating losses will cause shrinking current assets relative to total assets. 

b  = Retained Earnings to Total Assets = Retained Earnings
                                                               Total Assets

      This ratio measures a firm's success in using its total asset base to generate earnings.  However, manipulated retain earnings data can distort the numerical results.

c = EBIT to Total Assets = EBIT
                                      Total Assets

       The earnings before interest and taxes (EBIT) to total assets ratio, or the rate of return on assets, measures the productivity of a firm's assets.  Maximizing this rate is not the same as maximizing the rate of return on equity, since different degrees of leverage can affect conclusions.

d =  Equity to Debt = Market Value of Common + Preferred Stock
                                    Total Current Debt + Long Term Debt

      This ratio shows the amount a firm's assets can decline in value before liabilities exceed assets and the firm becomes insolvent.

e = Sales to Total Assets =  Total Sales
                                                 Total Assets

       This ratio is a measure of the firm's ability to generate sales.

       The "Z-Score" is a test to determine whether additional analysis is required, not an end in itself.  It is best to plot the "Z-Score" over time and compare it with averages for the industry.  A firm may have had a constantly low "Z-Score" for years and still have performed satisfactorily.

Z- Score Interpretation

Professor Altman's data indicates that: 

Z Score Prediction

          3.00  or more                             Little chance of bankruptcy

          1.81  to 2.99                              Some chance of bankruptcy

          1.80  or less                               Large chance of bankruptcy 

      It is noted that variants to Professor Altman's "Z-Score" formula have been calculated for a number of industries.  The analyst should examine the databases used to develop these models before placing too much reliance on them.  

Reference:  Altman, Edward I.  The Prediction of Corporate Bankruptcy:         a Discriminant Analysis.  Brief, Richard P., editor. Foundations of Accounting Series, No. 11.  149 pages, 1988, $30.00.  (ISBN D-8240-6113-6).  Garland Publishing, Inc.

APPENDIX E - Forms 


1. 
Standard Form 1407, Preaward Survey of Prospective Contractor Financial Capability

2. 
DCMA Form 1620, Guaranty Agreement for Corporate or Individual Guarantor (Applicable to one or more Government Contracts)

3. 
DCMA Form 1619, Subordination Agreement (Applicable to one or more than one  Government Contract) 

4. 
Standard Form 1408, (See FAR 53.301-1408)