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Chapter 2Chapter 2Analysis of Solvency, Liquidity, and Analysis of Solvency, Liquidity, and Financial FlexibilityFinancial Flexibility

OrderOrder Order Order Sale Sale Payment Sent Payment Sent CashCash PlacedPlaced Received Received ReceivedReceived Accounts CollectionAccounts Collection < Inventory > < Receivable > < Float >< Inventory > < Receivable > < Float >

Time ==>Time ==> Accounts Disbursement Accounts Disbursement

< Payable > < Float >< Payable > < Float > Invoice Received Payment Sent Invoice Received Payment Sent Cash DisbursedCash Disbursed

OrderOrder Order Order Sale Sale Payment Sent Payment Sent CashCash PlacedPlaced Received Received ReceivedReceived Accounts CollectionAccounts Collection < Inventory > < Receivable > < Float >< Inventory > < Receivable > < Float >

Time ==>Time ==> Accounts Disbursement Accounts Disbursement

< Payable > < Float >< Payable > < Float > Invoice Received Payment Sent Invoice Received Payment Sent Cash DisbursedCash Disbursed

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Learning ObjectivesLearning Objectives

Differentiate between solvency and liquidity ratiosDifferentiate between solvency and liquidity ratios Conduct a liquidity analysisConduct a liquidity analysis Assess a firm’s financial flexibility positionAssess a firm’s financial flexibility position

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Financial Statements - Basic Source Financial Statements - Basic Source of Informationof Information

Balance SheetBalance Sheet

Income StatementIncome Statement

Statement of Cash FlowsStatement of Cash Flows

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Solvency MeasuresSolvency Measures

Current RatioCurrent Ratio

Quick RatioQuick Ratio

Net Working CapitalNet Working Capital

Net Liquid BalanceNet Liquid Balance

Working Capital RequirementsWorking Capital Requirements

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Current RatioCurrent Ratio

Current assetsCurrent assetsCurrent ratio = -------------------------Current ratio = ------------------------- Current liabilitiesCurrent liabilities

$8,924$8,924Current ratio = ------------ = 1.00Current ratio = ------------ = 1.00 $8,933$8,933

19991999 2000 2000 2001 2002 2003 2001 2002 2003Current ratioCurrent ratio 1.72 1.72 1.48 1.48 1.45 1.05 1.00 1.45 1.05 1.00

Current assetsCurrent assetsCurrent ratio = -------------------------Current ratio = ------------------------- Current liabilitiesCurrent liabilities

$8,924$8,924Current ratio = ------------ = 1.00Current ratio = ------------ = 1.00 $8,933$8,933

19991999 2000 2000 2001 2002 2003 2001 2002 2003Current ratioCurrent ratio 1.72 1.72 1.48 1.48 1.45 1.05 1.00 1.45 1.05 1.00

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Quick RatioQuick Ratio

Current assets - InventoriesCurrent assets - InventoriesQuick ratio = -------------------------------------Quick ratio = ------------------------------------- Current liabilitiesCurrent liabilities

$8,924 - $306$8,924 - $306Quick ratio = ------------------- = .96Quick ratio = ------------------- = .96 $8,933$8,933

19991999 2000 2000 2001 2002 2003 2001 2002 2003Quick ratioQuick ratio 1.64 1.64 1.40 1.40 1.39 1.01 0.96 1.39 1.01 0.96

Current assets - InventoriesCurrent assets - InventoriesQuick ratio = -------------------------------------Quick ratio = ------------------------------------- Current liabilitiesCurrent liabilities

$8,924 - $306$8,924 - $306Quick ratio = ------------------- = .96Quick ratio = ------------------- = .96 $8,933$8,933

19991999 2000 2000 2001 2002 2003 2001 2002 2003Quick ratioQuick ratio 1.64 1.64 1.40 1.40 1.39 1.01 0.96 1.39 1.01 0.96

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Net Working CapitalNet Working Capital

Net working capital = CA - CLNet working capital = CA - CL

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

($000,000)($000,000) 1999 2000 2001 2002 2003 1999 2000 2001 2002 2003Net working capital $2,644 $2,489 $2,948 $358 ($9) Net working capital $2,644 $2,489 $2,948 $358 ($9)

Net working capital = CA - CLNet working capital = CA - CL

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

($000,000)($000,000) 1999 2000 2001 2002 2003 1999 2000 2001 2002 2003Net working capital $2,644 $2,489 $2,948 $358 ($9) Net working capital $2,644 $2,489 $2,948 $358 ($9)

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NWC and its Component PartsNWC and its Component Parts

CashCash

Mkt SecMkt Sec

A/RA/R

InventoryInventory

PrepaidPrepaid

A/PA/P

N/PN/P

CMLTDCMLTD

CashCash

Mkt SecMkt Sec

A/RA/R

InventoryInventory

PrepaidPrepaid

A/PA/P

N/PN/P

CMLTDCMLTD

CashCash

Mkt SecMkt Sec

A/RA/R

InventoryInventory

PrepaidPrepaid

A/PA/P

N/PN/P

CMLTDCMLTD

CA CL CA CL CA CLCA CL CA CL CA CL

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

Net Working Capital Net Working Capital

Working Capital Requirements Net Liquid BalanceWorking Capital Requirements Net Liquid Balance

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Working Capital RequirementsWorking Capital Requirements

($2,586+$306+$1,394) - ($5,989+$54+$1,458+$1,432)($2,586+$306+$1,394) - ($5,989+$54+$1,458+$1,432)WCR/S = -------------------------------------------------------------------WCR/S = -------------------------------------------------------------------

$35,404$35,404

($4,647)($4,647) = ---------- = -.1313= ---------- = -.1313

$35,404$35,404

1999 2000 2001 2002 20031999 2000 2001 2002 2003WCR/S - 0.029 -0.065 -0.078 -0.114 -0.131WCR/S - 0.029 -0.065 -0.078 -0.114 -0.131

($2,586+$306+$1,394) - ($5,989+$54+$1,458+$1,432)($2,586+$306+$1,394) - ($5,989+$54+$1,458+$1,432)WCR/S = -------------------------------------------------------------------WCR/S = -------------------------------------------------------------------

$35,404$35,404

($4,647)($4,647) = ---------- = -.1313= ---------- = -.1313

$35,404$35,404

1999 2000 2001 2002 20031999 2000 2001 2002 2003WCR/S - 0.029 -0.065 -0.078 -0.114 -0.131WCR/S - 0.029 -0.065 -0.078 -0.114 -0.131

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Net Liquid BalanceNet Liquid Balance

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

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

($000,000)($000,000) 1999 2000 2001 2002 2003 1999 2000 2001 2002 2003Net liquid balance $3,181 $4,132 $5,438 $3,914 $4,638Net liquid balance $3,181 $4,132 $5,438 $3,914 $4,638

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

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

($000,000)($000,000) 1999 2000 2001 2002 2003 1999 2000 2001 2002 2003Net liquid balance $3,181 $4,132 $5,438 $3,914 $4,638Net liquid balance $3,181 $4,132 $5,438 $3,914 $4,638

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What is Liquidity?What is Liquidity?

IngredientsIngredients– TimeTime

– AmountAmount

– CostCost

DefinitionDefinition– Having enough financial resources to cover financial obligations Having enough financial resources to cover financial obligations

in a timely manner with minimal costsin a timely manner with minimal costs

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What is Liquidity - ExamplesWhat is Liquidity - Examples

Amount and trend of internal cash flowAmount and trend of internal cash flow

Aggregate available credit linesAggregate available credit lines

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

Overall expertise of managementOverall expertise of management

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Liquidity MeasuresLiquidity Measures

Cash Flow From OperationsCash Flow From Operations

Cash Conversion EfficiencyCash Conversion Efficiency

Cash Conversion PeriodCash Conversion Period

Current Liquidity IndexCurrent Liquidity Index

LambdaLambda

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Cash Flow From OperationsCash Flow From Operations

($ 000,000) 1999 2000 2001 2002 2003($ 000,000) 1999 2000 2001 2002 2003CFFO $2,436 $3,926 $4,195 $3,797 $3,538CFFO $2,436 $3,926 $4,195 $3,797 $3,538

($ 000,000) 1999 2000 2001 2002 2003($ 000,000) 1999 2000 2001 2002 2003CFFO $2,436 $3,926 $4,195 $3,797 $3,538CFFO $2,436 $3,926 $4,195 $3,797 $3,538

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Cash Conversion EfficiencyCash Conversion Efficiency

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

(Percentage of sales)(Percentage of sales)Operating profit margin 11.21 9.72 8.68 7.28 8.03 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 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 efficiency 13.35 15.54 13.15 12.18 9.99

Cash conversion efficient = CFFO / SalesCash conversion efficient = CFFO / Sales

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

(Percentage of sales)(Percentage of sales)Operating profit margin 11.21 9.72 8.68 7.28 8.03 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 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 efficiency 13.35 15.54 13.15 12.18 9.99

Cash conversion efficient = CFFO / SalesCash conversion efficient = CFFO / Sales

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Cash Conversion ChartCash Conversion Chart

Inventory Inventory Inventory Inventory CashCashstocked sold stocked sold receivedreceived

Days inventory held Days sales outstandingDays inventory held Days sales outstanding

Days payables outstanding Days payables outstanding Cash conversionCash conversion periodperiod

Cash Cash disburseddisbursed

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Cash Conversion Period Cash Conversion Period CalculationsCalculations

Cash conversion period = DIH + DSO - DPOCash conversion period = DIH + DSO - DPO

(Days) 1999 2000 2001 2002 2003(Days) 1999 2000 2001 2002 2003DIHDIH 7.10 7.17 5.79 3.99 3.87 7.10 7.17 5.79 3.99 3.87 DSO 49.64 38.69 33.14 26.57 26.66DSO 49.64 38.69 33.14 26.57 26.66 ------- ------- ------- ------- -------------- ------- ------- ------- -------Operating cycleOperating cycle 56.74 45.86 38.93 30.56 30.53 56.74 45.86 38.93 30.56 30.53DPODPO 62.34 64.92 62.07 72.87 75.79 62.34 64.92 62.07 72.87 75.79

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

Cash conversion period = DIH + DSO - DPOCash conversion period = DIH + DSO - DPO

(Days) 1999 2000 2001 2002 2003(Days) 1999 2000 2001 2002 2003DIHDIH 7.10 7.17 5.79 3.99 3.87 7.10 7.17 5.79 3.99 3.87 DSO 49.64 38.69 33.14 26.57 26.66DSO 49.64 38.69 33.14 26.57 26.66 ------- ------- ------- ------- -------------- ------- ------- ------- -------Operating cycleOperating cycle 56.74 45.86 38.93 30.56 30.53 56.74 45.86 38.93 30.56 30.53DPODPO 62.34 64.92 62.07 72.87 75.79 62.34 64.92 62.07 72.87 75.79

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

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How Much Liquidity is Enough?How Much Liquidity is Enough?

Solvency - a stock or balance perspectiveSolvency - a stock or balance perspective

Liquidity - a flow perspectiveLiquidity - a flow perspective

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

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Current Liquidity IndexCurrent Liquidity Index

Cash assets Cash assets t-1t-1 + CFFO + CFFO t t

CLI = ---------------------------------CLI = --------------------------------- N/P N/P t-1t-1 + CMLTD + CMLTD t-1 t-1

$4,638 + $3,538$4,638 + $3,538CLI = --------------------- = infiniteCLI = --------------------- = infinite

$0 + $0$0 + $0

Cash assets Cash assets t-1t-1 + CFFO + CFFO t t

CLI = ---------------------------------CLI = --------------------------------- N/P N/P t-1t-1 + CMLTD + CMLTD t-1 t-1

$4,638 + $3,538$4,638 + $3,538CLI = --------------------- = infiniteCLI = --------------------- = infinite

$0 + $0$0 + $0

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LambdaLambda

Initial liquid Total anticipated net cash flow Initial liquid Total anticipated net cash flow reserve + during the analysis horizonreserve + during the analysis horizon

Lambda = -------------------------------------------------------------------Lambda = -------------------------------------------------------------------Uncertainty about the net cash flow during theUncertainty about the net cash flow during theanalysis horizonanalysis horizon

Initial liquid Total anticipated net cash flow Initial liquid Total anticipated net cash flow reserve + during the analysis horizonreserve + during the analysis horizon

Lambda = -------------------------------------------------------------------Lambda = -------------------------------------------------------------------Uncertainty about the net cash flow during theUncertainty about the net cash flow during theanalysis horizonanalysis horizon

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Financial FlexibilityFinancial Flexibility

Sustainable Growth Rate Concept:Sustainable Growth Rate Concept:

Uses = SourcesUses = SourcesNew Assets = New Equity + New DebtNew Assets = New Equity + New Debt gS(A/S) = m(S+gS)(1-d) + m(S+gS)(1-d)(D/E)gS(A/S) = m(S+gS)(1-d) + m(S+gS)(1-d)(D/E)

m(1-d)[1 + (D/E)]m(1-d)[1 + (D/E)] g = ----------------------------------g = ----------------------------------

(A/S) - {m(1-d)[1 + (D/E)]}(A/S) - {m(1-d)[1 + (D/E)]}

.039977 x (1 - 0.00) x (1 + 1.8834).039977 x (1 - 0.00) x (1 + 1.8834) g = ----------------------------------------------------- = 36.14%g = ----------------------------------------------------- = 36.14% .43426 - [0.039977 x (1 - 0.00)(1 + 1.8834)].43426 - [0.039977 x (1 - 0.00)(1 + 1.8834)]calculation uses 2002 data to calculate the sustainable 2003 g.calculation uses 2002 data to calculate the sustainable 2003 g.

Sustainable Growth Rate Concept:Sustainable Growth Rate Concept:

Uses = SourcesUses = SourcesNew Assets = New Equity + New DebtNew Assets = New Equity + New Debt gS(A/S) = m(S+gS)(1-d) + m(S+gS)(1-d)(D/E)gS(A/S) = m(S+gS)(1-d) + m(S+gS)(1-d)(D/E)

m(1-d)[1 + (D/E)]m(1-d)[1 + (D/E)] g = ----------------------------------g = ----------------------------------

(A/S) - {m(1-d)[1 + (D/E)]}(A/S) - {m(1-d)[1 + (D/E)]}

.039977 x (1 - 0.00) x (1 + 1.8834).039977 x (1 - 0.00) x (1 + 1.8834) g = ----------------------------------------------------- = 36.14%g = ----------------------------------------------------- = 36.14% .43426 - [0.039977 x (1 - 0.00)(1 + 1.8834)].43426 - [0.039977 x (1 - 0.00)(1 + 1.8834)]calculation uses 2002 data to calculate the sustainable 2003 g.calculation uses 2002 data to calculate the sustainable 2003 g.

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SummarySummary

Chapter introduced basic concepts of:Chapter introduced basic concepts of:– solvencysolvency

– liquidityliquidity

– financial flexibilityfinancial flexibility

SolvencySolvency: an accounting concept comparing assets to : an accounting concept comparing assets to liabilities.liabilities.

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

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