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chapter 2 analysis of solvency liquidity and financial flexibility
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
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
Financial Statements - Basic Source of Information
  • Balance Sheet
  • Income Statement
  • Statement of Cash Flows
solvency measures
Solvency Measures
  • Current Ratio
  • Quick Ratio
  • Net Working Capital
  • Net Liquid Balance
  • Working Capital Requirements
current ratio
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
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
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

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
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
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
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
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
Liquidity Measures
  • Cash Flow From Operations
  • Cash Conversion Efficiency
  • Cash Conversion Period
  • Current Liquidity Index
  • Lambda
cash flow from operations
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
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
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
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
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
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
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
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
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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