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Chapter 2 Analysis of Solvency, Liquidity, and Financial Flexibility

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Chapter 2 analysis of solvency liquidity and financial flexibility l.jpg

Chapter 2Analysis of Solvency, Liquidity, and Financial Flexibility

  • Order Order Sale Payment Sent Cash

  • Placed Received Received

  • Accounts Collection

  • < Inventory > < Receivable > < Float >

  • Time ==>

    • Accounts Disbursement

  • < Payable > < Float >

  • Invoice Received Payment Sent Cash Disbursed


  • Learning objectives l.jpg

    Learning Objectives

    • Differentiate between solvency and liquidity ratios

    • Conduct a liquidity analysis

    • Assess a firm’s financial flexibility position


    Financial statements basic source of information l.jpg

    Financial Statements - Basic Source of Information

    • Balance Sheet

    • Income Statement

    • Statement of Cash Flows


    Solvency measures l.jpg

    Solvency Measures

    • Current Ratio

    • Quick Ratio

    • Net Working Capital

    • Net Liquid Balance

    • Working Capital Requirements


    Current ratio l.jpg

    Current Ratio

    • Current assets

    • Current ratio = -------------------------

    • Current liabilities

    • $8,924

    • Current ratio = ------------ = 1.00

    • $8,933

      • 1999 2000 2001 2002 2003

  • Current ratio 1.72 1.48 1.45 1.05 1.00


  • Quick ratio l.jpg

    Quick Ratio

    • Current assets - Inventories

    • Quick ratio = -------------------------------------

    • Current liabilities

    • $8,924 - $306

    • Quick ratio = ------------------- = .96

    • $8,933

      • 1999 2000 2001 2002 2003

  • Quick ratio 1.64 1.40 1.39 1.01 0.96


  • Net working capital l.jpg

    Net Working Capital

    Net working capital = CA - CL

    Net working capital = $8,924 - $8,933

    = ($9)

    ($000,000) 1999 2000 2001 2002 2003

    Net working capital $2,644 $2,489 $2,948 $358 ($9)


    Nwc and its component parts l.jpg

    Cash

    Cash

    Cash

    Mkt Sec

    Mkt Sec

    Mkt Sec

    A/R

    A/P

    A/R

    A/P

    A/R

    A/P

    Inventory

    N/P

    Inventory

    N/P

    Inventory

    N/P

    Prepaid

    CMLTD

    Prepaid

    CMLTD

    Prepaid

    CMLTD

    NWC and its Component Parts

    CA CL CA CL CA CL

    NWC = CA - CL WCR = A/R + INV +Pre NLB = Cash + M/S

    - A/P - N/P - CMLTD

    Net Working Capital

    Working Capital Requirements Net Liquid Balance


    Working capital requirements l.jpg

    Working Capital Requirements

    • ($2,586+$306+$1,394) - ($5,989+$54+$1,458+$1,432)

    • WCR/S = -------------------------------------------------------------------

      • $35,404

      • ($4,647)

  • = ---------- = -.1313

  • $35,404

  • 1999 2000 2001 2002 2003

  • WCR/S - 0.029 -0.065 -0.078 -0.114 -0.131


  • Net liquid balance l.jpg

    Net Liquid Balance

    • Net liquid balance = Cash + Equiv. - (N/P + CMLTD)

    • Net liquid balance = $4,638 - ($0)

      • = $4,638

  • ($000,000) 1999 2000 2001 2002 2003

  • Net liquid balance $3,181 $4,132 $5,438 $3,914 $4,638


  • What is liquidity l.jpg

    What is Liquidity?

    • Ingredients

      • Time

      • Amount

      • Cost

    • Definition

      • Having enough financial resources to cover financial obligations in a timely manner with minimal costs


    What is liquidity examples l.jpg

    What is Liquidity - Examples

    • Amount and trend of internal cash flow

    • Aggregate available credit lines

    • Attractiveness of firm’s commercial paper and other financial instruments

    • Overall expertise of management


    Liquidity measures l.jpg

    Liquidity Measures

    • Cash Flow From Operations

    • Cash Conversion Efficiency

    • Cash Conversion Period

    • Current Liquidity Index

    • Lambda


    Cash flow from operations l.jpg

    Cash Flow From Operations

    ($ 000,000) 1999 2000 2001 2002 2003

    CFFO $2,436 $3,926 $4,195 $3,797 $3,538


    Cash conversion efficiency l.jpg

    Cash Conversion Efficiency

    ($ 000,000) 1999 2000 2001 2002 2003

    CFFO $2,436 $3,926 $4,195 $3,797 $3,538

    Revenues 18,243 25,265 31,888 31,168 35,404

    Operating profit 2,046 2,457 2,768 2,271 2,844

    Net profit 1,460 1,666 2,177 1,246 2,122

    (Percentage of sales)

    Operating profit margin 11.21 9.72 8.68 7.28 8.03

    Net profit margin 8.00 6.59 6.82 3.99 5.99

    Cash conversion efficiency 13.35 15.54 13.15 12.18 9.99

    Cash conversion efficient = CFFO / Sales


    Cash conversion chart l.jpg

    Cash Conversion Chart

    Inventory Inventory Cash

    stocked sold received

    Days inventory held Days sales outstanding

    Days payables outstanding Cash conversion

    period

    Cash

    disbursed


    Cash conversion period calculations l.jpg

    Cash Conversion Period Calculations

    Cash conversion period = DIH + DSO - DPO

    (Days) 1999 2000 2001 2002 2003

    DIH 7.10 7.17 5.79 3.99 3.87

    DSO 49.64 38.69 33.14 26.57 26.66

    ------- ------- ------- ------- -------

    Operating cycle 56.74 45.86 38.93 30.56 30.53

    DPO 62.34 64.92 62.07 72.87 75.79

    ------- ------- ------- ------- -------

    Cash conversion period -5.60 -19.06 -23.14 -42.31 -45.26


    How much liquidity is enough l.jpg

    How Much Liquidity is Enough?

    • Solvency - a stock or balance perspective

    • Liquidity - a flow perspective

    • Liquidity management involves finding the right balance of stocks and flows


    Current liquidity index l.jpg

    Current Liquidity Index

    • Cash assets t-1 + CFFO t

  • CLI = ---------------------------------

    • N/P t-1 + CMLTD t-1

  • $4,638 + $3,538

  • CLI = --------------------- = infinite

    • $0 + $0


  • Lambda l.jpg

    Lambda

    • Initial liquid Total anticipated net cash flow

      • reserve + during the analysis horizon

  • Lambda = -------------------------------------------------------------------

    • Uncertainty about the net cash flow during the

    • analysis horizon


  • Financial flexibility l.jpg

    Financial Flexibility

    • Sustainable Growth Rate Concept:

    • Uses = Sources

    • New Assets = New Equity + New Debt

    • gS(A/S) = m(S+gS)(1-d) + m(S+gS)(1-d)(D/E)

      • m(1-d)[1 + (D/E)]

  • g = ----------------------------------

    • (A/S) - {m(1-d)[1 + (D/E)]}

    • .039977 x (1 - 0.00) x (1 + 1.8834)

    • g = ----------------------------------------------------- = 36.14%

    • .43426 - [0.039977 x (1 - 0.00)(1 + 1.8834)]

    • calculation uses 2002 data to calculate the sustainable 2003 g.


  • Summary l.jpg

    Summary

    • Chapter introduced basic concepts of:

      • solvency

      • liquidity

      • financial flexibility

    • Solvency: an accounting concept comparing assets to liabilities.

    • Liquidity: related to a firm’s ability to pay for its current obligations in a timely fashion with minimal costs.

    • Financial flexibility: related to a firm’s overall financial structure and if financial policies allows firm enough flexibility to take advantage of unforeseen opportunities.


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