Chapter 2 Analysis of Solvency, Liquidity, and Financial Flexibility

Order Placed Order Received < Inventory > Payment Sent Cash Received Accounts Collection < Receivable > < Float > Sale

Time ==>
Accounts < Payable > Disbursement < Float >

Invoice Received

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Learning Objectives
Differentiate between solvency and liquidity ratios Conduct a liquidity analysis Assess a firms financial flexibility position

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Financial Statements - Basic Source of Information

Balance Sheet Income Statement Statement of Cash Flows

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Solvency Measures

Current Ratio Quick Ratio Net Working Capital

Net Liquid Balance

Working Capital Requirements

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Current Ratio

Current assets Current ratio = ------------------------Current liabilities $8,924 Current ratio = ------------ = 1.00 $8,933 1999 1.72 2000 1.48 2001 1.45 2002 1.05 2003 1.00

Current ratio

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Quick Ratio

Current assets - Inventories Quick ratio = ------------------------------------Current liabilities $8,924 - $306 Quick ratio = ------------------- = .96 $8,933 1999 1.64 2000 1.40 2001 1.39 2002 1.01 2003 0.96

Quick ratio

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Net Working Capital

Net working capital = CA - CL

Net working capital = $8,924 - $8,933 = ($9)

($000,000) 1999 2000 2001 Net working capital $2,644 $2,489 $2,948

2002 $358

2003 ($9)

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NWC and its Component Parts

CA Cash Mkt Sec A/R Inventory Prepaid A/P N/P CMLTD CL CA Cash Mkt Sec A/R Inventory Prepaid A/P N/P CMLTD CL CA Cash Mkt Sec A/R Inventory Prepaid A/P N/P CMLTD CL

NWC = CA - CL

WCR = A/R + INV +Pre - A/P Working Capital Requirements Copyright

NLB = Cash + M/S - N/P - CMLTD

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Net Working Capital

Net Liquid Balance

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 - 0.029 -0.065 -0.078 -0.114 2003 -0.131

WCR/S

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Net Liquid Balance

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

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

($000,000) Net liquid balance

1999 2000 2001 2002 2003 $3,181 $4,132 $5,438 $3,914 $4,638

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What is Liquidity?

Ingredients
Time Amount Cost

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

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What is Liquidity - Examples

Amount and trend of internal cash flow Aggregate available credit lines Attractiveness of firms commercial paper and other financial instruments Overall expertise of management

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Liquidity Measures

Cash Flow From Operations Cash Conversion Efficiency Cash Conversion Period

Current Liquidity Index

Lambda

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Cash Flow From Operations

($ 000,000) CFFO

1999 2000 2001 2002 2003 $2,436 $3,926 $4,195 $3,797 $3,538

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Cash Conversion Efficiency

($ 000,000) CFFO Revenues Operating profit Net profit 1999 2000 2001 2002 2003 $2,436 $3,926 $4,195 $3,797 $3,538 18,243 25,265 31,888 31,168 35,404 2,046 2,457 2,768 2,271 2,844 1,460 1,666 2,177 1,246 2,122

(Percentage of sales) Operating profit margin 11.21 Net profit margin 8.00 Cash conversion efficiency 13.35

9.72 6.59 15.54

8.68 6.82 13.15

7.28 3.99 12.18

8.03 5.99 9.99

Cash conversion efficient = CFFO / Sales

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Cash Conversion Chart

Inventory stocked

Inventory sold

Cash received

Days inventory held

Days sales outstanding

Days payables outstanding

Cash conversion period Cash disbursed

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Cash Conversion Period Calculations

Cash conversion period = DIH + DSO - DPO (Days) DIH DSO 1999 2000 2001 2002 2003 7.10 7.17 5.79 3.99 3.87 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
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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

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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

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Lambda

Initial liquid Total anticipated net cash flow reserve + during the analysis horizon Lambda = ------------------------------------------------------------------Uncertainty about the net cash flow during the analysis horizon

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Financial Flexibility
Sustainable Growth Rate Concept: Uses New Assets gS(A/S) = Sources = New Equity + New Debt = 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. Copyright 2005 by Thomson Learning, Inc.

Summary

Chapter introduced basic concepts of:

solvency liquidity financial flexibility

Solvency: an accounting concept comparing assets to liabilities. Liquidity: related to a firms ability to pay for its current obligations in a timely fashion with minimal costs. Financial flexibility: related to a firms overall financial structure and if financial policies allows firm enough flexibility to take advantage of unforeseen opportunities.

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