Corporate Liquidity

8/8/2019 Corporate Liquidity

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CORPORATECORPORATELIQUIDITYLIQUIDITY



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INTRODUCTIONINTRODUCTION

The term liquidity probably brings to mind the relationshipof current assets to current liabilities. An essentialcomponent of liquidity is the time an asset takes to beconverted into cash or the time it takes to pay a current

liability. More simply, this may be stated as the ability of the firm to pay its bills on time. Liquidity may also beviewed as the ability of the firm to augment its future cashflows to cover any unforeseen needs or to take advantageof any unforeseen opportunities. This concept of liquidityhas been referred to as financial flexibility.



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TRADITIONAL MEASURES OFTRADITIONAL MEASURES OFLIQUIDITYLIQUIDITY

Although the ratio presented in this section are generallyreferred to as liquidity ratio, most of them especially the

current and quick ratios, really measure the solvency of thefirm. A firm is considered solvent when its total assetsexceed its total liabilities.



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LIQUIDITY RATIOLIQUIDITY RATIO

Liquidity and short term solvency ratios are used to judgethe firm¶s ability to meet such current obligations as itsaccounts payable and the current position of its long-termdebt. By interpreting such ratios we can determine the

degree to which assets which are quickly convertible tocash exceed the liabilities which require almost immediatecash payment. Liquidity ratios are generally useful to allfinancial statement users, but are particularly useful toshort-term creditors. The most frequently ratios in thiscategory are:-

1. CURRENT RATIO

2. QUICK (ACID TEST) RATIO



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CURRENT RATIOCURRENT RATIO

The current ratio is the traditional ratio used to measure a

company¶s liquidity and is calculated by dividing the totalcurrent assets by the total current liabilities.

CURRENT RATIO = Current Assets / Current Liabilities

Current Assets:-

Cash in hand, cash at bank, sundry

debtors, bills receivables (B/R),inventory, prepaid expenses, accruedincome etc.

Current Liabilities:-

Bank overdraft, sundry creditors,outstanding expenses (o/s exp.), billspayable (B/P), income received inadvance etc.

IDLE RATIO = 2:1



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QUICK (ACID TEST) RATIOQUICK (ACID TEST) RATIO

A supplementary test of the ability of a business to meet itscurrent obligation is the quick or the acid test ratio. Thequick ratio is calculated by dividing the liquid assets bycurrent liabilities.

QUICK RATIO = Liquid Assets / Current Liabilities

Liquid Assets:-

Current Assets ± Inventory ± PrepaidExpenses

Current Liabilities:-

Bank overdraft, sundry creditors,outstanding expenses (o/s exp.), billspayable (B/P), income received inadvance etc.

IDLE RATIO = 1:1



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ACTIVITY RATIOACTIVITY RATIO

Activity ratios reflect the intensity with which the firm usesassets in generating sales. If investment in an asset is toolarge, it could be that the funds tied up in that asset shouldbe used for more immediate productive purpose. If

investment is too small, the firm may be providing poorservice to the customers or inefficiently, providing itsproduct. Some of the activity ratios, which are also referredto as efficiency or turnover are discussed below:-

1. Receivable Turnover Ratio2. Inventory Turnover Ratio



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RECEIVABLE TURNOVER RATIORECEIVABLE TURNOVER RATIO

The sundry debtors turnover is a measure of the number of tomes on the average that receivables turnover each year.This ratio is computed by dividing net credit sales by theaverage receivable outstanding during the year. Averagesundry debtors are calculated by taking the average of thecurrent and previous year-end sundry debtors balances.

DEBTORS TURNOVER RATIO = Net Credit Sales / AverageDebtors

AVERAGE COLLECTION PERIOD

=Number of Days in a Year /Debtors Turnover Ratio



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INVENTORY TURNOVER RATIOINVENTORY TURNOVER RATIO

Inventory turnover is a measure of the number of times theaverage inventory has been sold during the year. It iscomputed by dividing the cost of goods sold by the averageinventory.

INVENTORY TURNOVER RATIO = Cost of Goods Sold /Average Inventory

AVERAGE INVENTORY TURNOVER IN DAYS

= Number of Days in a Year /Inventory Turnover Ratio



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NET WORKING CAPITALNET WORKING CAPITAL

Another common liquidity measure is net working capital.Net working capital is the difference between current assetsand current liabilities. It is generally agreed that thegreater the current assets relative to the level of currentliabilities, the more liquid the company.

NET WORKING CAPITAL = Current Assets ± CurrentLiabilities



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WORKING CAPITAL APPROACHWORKING CAPITAL APPROACH

Working capital is defined as current assets minus currentliabilities. It is a broader definition of ³funds´ than justcash, but bear in mind that cash is one component of working capital. The statement of changes in financialposition on a working capital basis includes information

relating to the changes in working capital based on thevarious sources and uses of funds.

The statement of sources and uses of capital gives a picturepf management¶s handling of circulating capital. It is,therefore, a ³window´ through which the analyst can closely

examine one phase of management¶s planning and decisionmaking



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SOURCES AND USES OF WORKINGSOURCES AND USES OF WORKING

CAPITALCAPITALThe statement of changes in financial position is dividedinto two major segments: funds that the firm has obtainedduring the period (sources of funds) and the outflow of funds which has occurred (use of funds). The ³sources of

funds´ section summarises all transactions of the businessthat caused an increase in working capital.



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SOURCES OF WORKING CAPITALSOURCES OF WORKING CAPITAL

Transactions that increase working capital are sources of

funds. The primary sources of working capital of a firminclude:FUNDS GENERATED FROM OPERATIONS:

The earning of a business represent one of the principal µsources of funds¶. The amount of funds generated from

operations is not the net income shown on the incomestatement, however, because some of expenses, principallydepreciation and amortisation, do not involve theexpenditure of funds. In order to determine working capitalprovided by operations, it is necessary to deduct fromrevenues those expenses which required an expenditure of funds and therefore caused a decrease in working capital.

COMPUTAION OF WORKING CAPITAL FUND PROVIDED BYOPERATIONS = Net Income + Items Reducing Net IncomeWhich Do Not Affect Working Capital + Non OperatingLosses ± Non Operating Gains ± Items Increasing NetIncome Which Do Not Affect Working Capital



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SOME SOURCES OF FUNDSSOME SOURCES OF FUNDS

Increase in long-term liabilities

Increase in share capital

Sale of non current assets etc.



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USES OF FUNDSUSES OF FUNDS

Transactions that decrease working capital are classifies as

uses of funds. Typically uses of working capital include:-

Purchase of non current assets

Dividends

Decrease in long-term liabilities etc.



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TRANSACTIONS THAT INCREASETRANSACTIONS THAT INCREASEWORKING CAPITALWORKING CAPITAL

S. No. Type of Transactions

Example Working Capital Effect

1. Long-Term Assetsto Current Assets

Sale of a FixedAssets (e.g. Mach.)

Increase in Cash or Receivableequal to the proceed of sale

2. Long-TermLiabilities toCurrent Assets

Issuance of Debenture

Increase in cash equal todebenture issued.

3. Owner¶s Equity toCurrent Assets

Earning of Profit Increase in Cash andReceivables from Revenue LessCurrent Assets Consumed andPayments and Accruals forCurrent Expenses

4. Long-Term Assetsto CurrentLiabilities

Transfer of a Long-Term Asset

Decrease in Current Liabilityequal to amount of DebtSatisfied

5. Current Liabilitiesin Long-TermLiabilities

Exchange of Current Creditor indebenture

Decrease in Creditor equal toamount of debenture issued.

6. Current Liabilitiesto Owner¶s Equity

Insurance of Sharesto a Creditor tosatisfy a currentdebt.

Decrease in Current LiabilityEqual to Amount of DebtSatisfied.



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TRANSACTIONS THAT DECREASETRANSACTIONS THAT DECREASEWORKING CAPITALWORKING CAPITAL

S. No. Type of Transactions

Example Working Capital Effect

1. Current Assets toLong-Term Assets

Purchase of FixedAsset (e.g. Building)

Decrease in Cash Equal toAmount of Cash Actually Paid

2. Current Assets toLong-TermLiabilities

Debentures PayablePaid from Cash

Decrease in Cash Equal toAmount to Reduce the Debt

3. Current Assets toOwner¶s Equity

Incurring a Net Lossfrom operating

Will Decrease Working CapitalOnly if Cash Paid for and Accrualsof Current Expenses Plus CurrentAssets Consumed During theYear Exceed Cash and ReceivableDerived from Revenues

4. Current Liabilitiesto Long-TermAssets

Purchase of FixedAsset on Short-termCredit

Increase in Creditors Equal toAmount of Fixed Asset

5. Owner¶s Equity toCurrent Liabilities

Declaration of CashDividend

Increase of Current Liability as of the Date of declaration Equal toAmount to be Paid

6. Long-TermLiabilities toCurrent Liabilities

Current Maturities of Long-Term Debt

Increase in Current Liabilities if the Current Liabilities are to bePaid from Working Capital



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SOURCES AND USES OF CASHSOURCES AND USES OF CASHAPPROACHAPPROACH

There are changes in financial position that do not affectfunds flow, yet should be included in the funds flowstatement. If funds are defined as cash, the statement of changes in financial position disclose individual sources anduse of cash. The analysis of cash flow is very similar to the

analysis which was described for the working capitalconcept of funds. Additional adjustments, however, arenecessary to convert the net income for the period to theamount of cash which was provided by operations.



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CASH FLOW FROM OPERATIONSCASH FLOW FROM OPERATIONS

Several adjustments are required to convert a firm¶s netincome to cash flow operations. A non-fund expenses, suchas depreciation, is an allocation of a past cost and thusdoes not result in an outlay of cash during the current

period. Therefore, non fund expenses must be added backto net income in determining cash provided by operations.



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COMPUTATION OF CASH FROMCOMPUTATION OF CASH FROMOPERATIONSOPERATIONS

Net income as per income statement (P&L A/c) ««««««.

Add: Non±Fund Expenses

Depreciation ««««««.

Amortization/Write 0ff of Patents, preliminary ««««........

Expenses or Loss on sale of Fixed assets «««««««.

Deduct: Profit on sale of fixed assets «««««..

Net Working Capital or funds provided by operations (A)

Add: Decrease in Current Assets «««.

Increase in Current Liabilities «««..

Deduct: Increase in Current Assets ..«««.Decrease in Current Liabilities ««««

Net Charge (B)

Cash Generated by operations (A)+(B)



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Corporate Liquidity

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