Balance sheet assets. We will now look at financial risk as it relates to the quality of the assets on the balance sheet. Our first measure of asset quality from a credit perspective is the certainty with which assets can be turned into cash to meet obligations. Cash and marketable securities have the most certainty obviously. Working capital can have a high degree of certainty as well, but it depends on the assets themselves. Is the company carrying a lot of accounts receivable and will those customers ultimately pay? Is the inventory valuable or not? We'll discuss these in a moment. Also, many companies have negative working capital, meaning that the working liabilities are greater than the working assets. Now, this is not necessarily a bad thing from an operational funding perspective, but in a liquidation, it is not necessarily the best thing. Fixed assets have a higher degree of risk, depending on their nature and on their age. Intangibles carry a very high risk. Patents and intellectual property might have value, but goodwill is useless. Finally, associate investments and JVs have a very high level of risk as the assets are owned but not controlled by the company. There are also obligations and guarantees that might be present. In some cases, these can be a source of immediate cash. For example, Nestle has owned an equity stake in L'Oreal for years and in dire circumstances could very easily sell it. That is a rare example. However, also it should be noted that when companies own an equity stake in a corporation, which is generally 20 to 50%, it's not something that they can just easily dump onto the market. That type of sale usually has to be arranged through an equity capital markets desk, and that can take time. Assets need to demonstrate that they are high quality and have cash generating ability. These are some questions we need to ask about our OWC assets for accounts receivable. How great are the allowances for bad debt and are there significant customer concentrations? Are there problems collecting for inventory? Which method is being used for costing? If it's LIFO, are there older li o layers that are of less value? Is the inventory turning over fast enough? What is the deferred tax situation? Is it an asset or liability? Is it consistent? Are there NOLs or net operating losses? We also consider the accounts payable here, which is obviously a liability, and we do this because we would want to know if there are any issues with suppliers. We also need to understand the cash generating ability of OWC. We'll discuss OWC and cash flow later, but the efficiency ratios at the bottom are going to help us understand how these working assets and liabilities behave. Fixed assets need to be replenished and will increase in a growing company. Although CapEx is an area that often comes up in loan covenant restrictions and sensitivity analysis, we have to remember that no company can grow without investing in its asset base. We generally think of CapEx as having two components, expansion and maintenance, expansion being for growth. Also, there are adjustments made by the agencies for capitalized interest. Capitalized Interest is when the cost of financing the construction or acquisition of an asset is added to the asset cost Itself. The agencies will remove that interest cost from the asset and add it directly to interest expense. Below are some informative asset based ratios. The fixed asset ratio tells us the efficiency of the PP&E in delivering sales. The CapEx ratio looks at investment in relation to sales. The average age of PP&E ratio appraises the age of the borrower's equipment and might give an indication of future CapEx. The reinvestment ratio tells if the company is spending to grow or to maintain. All these ratios must be looked at in comparison to its industry competitors.
