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Chapter 2Chapter 2

Analysis of Solvency, Liquidity, andAnalysis of Solvency, Liquidity, and

Financial FlexibilityFinancial Flexibility

OrderOrder OrderOrder SaleSale CashCash

PlacedPlaced ReceivedReceived Received Received

Accounts CollectionAccounts Collection

< Inventory > < Receivable > < Float >< Inventory > < Receivable > < Float >

Time ==>Time ==>

Accounts DisbursementAccounts Disbursement

< Payable > < Float >< Payable > < Float >

InvoiceInvoice PaymentPayment CashCash

Received SentReceived Sent Paid Paid

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Learning ObjectivesLearning Objectives

y Differentiate between solvency, liquidity,

and financial flexibility ratios

y Recognize that liquidity, broadly defined,

includes solvency, narrow liquidity, and

financial flexibility

y Conduct a solvency analysis

y Conduct a liquidity analysis

y Assess a firm·s financial flexibility position

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Financial StatementsFinancial Statements -- Basic SourceBasic Source

of Informationof Informationy Balance Sheet

y Income Statement

y Statement of Cash Flows

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Solvency MeasuresSolvency Measures

y Current Ratio

y Quick Ratio

y Net Working Capital

y

Net Liquid Balance(really gets at liquidity, too)

y Working Capital Requirements

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Current RatioCurrent Ratio

Current assetsCurrent assets

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

Current liabilitiesCurrent liabilities

$6,339$6,339

Current ratio =Current ratio = ---------------------- = 1.72= 1.72

$3,695$3,695

19951995 19961996 1997 1998 19991997 1998 1999

Current ratioCurrent ratio 1.961.96 2.082.08 1.66 1.45 1.721.66 1.45 1.72

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Quick RatioQuick Ratio

Current assetsCurrent assets -- InventoriesInventories

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

Current liabilitiesCurrent liabilities

$6,339$6,339 -- $273$273

Quick ratio =Quick ratio = ---------------------------------------- = 1.64= 1.64

$3,695$3,695

19951995 19961996 1997 1998 19991997 1998 1999

Quick ratioQuick ratio 1.571.57 1.631.63 1.51 1.36 1.641.51 1.36 1.64

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Net Working CapitalNet Working Capital

Net working capital = CANet working capital = CA -- CLCL

Net working capital = $6,339Net working capital = $6,339 -- $3,695$3,695

= $2,644= $2,644

($ Millions)($ Millions) 1995 1996 1997 1998 19991995 1996 1997 1998 1999

Net working capital $ 719 $1,018 $1,089 $1,215 $2,644Net working capital $ 719 $1,018 $1,089 $1,215 $2,644

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NWC and its Component PartsNWC and its Component Parts

CashCash

Mkt SecMkt Sec

A/R A/R

InventoryInventory

PrepaidPrepaid

N/PN/P

CashCash

Mkt SecMkt Sec

A/R A/R

InventoryInventory

PrepaidPrepaid

CashCash

Mkt SecMkt Sec

A/R A/R

InventoryInventory

PrepaidPrepaid

CA CL CA CL CA CLCA CL CA CL CA CL

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

-- A/P A/P -- N/P N/P -- CMLTDCMLTD

NetWorking Capital =NetWorking Capital = Working Capital Requirements + Net Liquid BalanceWorking Capital Requirements + Net Liquid Balance

A/PA/P A/PA/P A/PA/P

N/PN/P

CMLTDCMLTD

N/PN/P

CMLTDCMLTDCMLTDCMLTD

AccrualsAccruals AccrualsAccruals AccrualsAccruals

-- AccrualsAccruals

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Working Capital RequirementsWorking Capital Requirements

($2,481+$273+$404)($2,481+$273+$404) -- ($2,397+$355+$943)($2,397+$355+$943)

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

$18,243$18,243

($537)($537)

== ---------------------- == --0.0290.029

$18,243$18,243

1995 1996 1997 1998 19991995 1996 1997 1998 1999

WCR/S .055 .082WCR/S .055 .082 --.030.030 --.039.039 --.029.029

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Net Liquid BalanceNet Liquid Balance

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

Net liquid balance = $3,181Net liquid balance = $3,181 -- $0$0

= $3,181= $3,181

($ Millions)($ Millions) 1995 1996 1997 1998 19991995 1996 1997 1998 1999Net liquid balance $527 $586 $1,325 $1,698 $3,181Net liquid balance $527 $586 $1,325 $1,698 $3,181

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What is Liquidity?What is Liquidity?

y Ingredients

Time

Amount

Cost

y Definition

´ Having enough financial resources to cover

financial obligations in a timely manner withminimal costsµ

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What is LiquidityWhat is Liquidity -- ExamplesExamples

y Amount and trend of internal cash flow

y Aggregate available credit lines

y Attractiveness of firm·s commercial paper

and other financial instruments

y Overall expertise of management

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Liquidity Measures (NarrowLiquidity Measures (Narrow

Liquidity)Liquidity)y Cash Flow From Operations

from Statement of Cash Flows

y Cash Conversion Period

y Current Liquidity Index

y Lambda (also financial flexibility measure;

more on this later)

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Cash Flow From OperationsCash Flow From Operations

($ Millions) 1995 1996 1997 1998 1999($ Millions) 1995 1996 1997 1998 1999

CFFO $243.4 $175.0 $1,362.0 $1,592.0 $2,436.0CFFO $243.4 $175.0 $1,362.0 $1,592.0 $2,436.0

Dell¶s Cash Flow From OperationsDell¶s Cash Flow From Operations

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Cash Conversion ChartCash Conversion Chart

Inventory InventoryInventory Inventory CashCash

stocked soldstocked sold receivedreceived

Days inventory held Days sales outstandingDays inventory held Days sales outstanding

Days payables outstandingDays payables outstanding Cash conversionCash conversionperiodperiod

CashCash

disburseddisbursed

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Cash Conversion PeriodCash Conversion Period

CalculationsCalculations

Cash conversion period = DIH + DSOCash conversion period = DIH + DSO -- DPODPO

(Days)(Days) 19951995 19961996 19971997 19981998 19991999

DIHDIH 40 37 15 9 740 37 15 9 7

DSO 57 50 42 44 50DSO 57 50 42 44 50

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

Operating cycleOperating cycle 97 87 57 53 5797 87 57 53 57

DPODPO 60 41 63 63 6260 41 63 63 62-------------- -------------- -------------- -------------- --------------

Cash conversion period 37 46Cash conversion period 37 46 --66 --1010 --55

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

y Solvency - a stock or balance perspective

y Liquidity - a flow perspective

y Liquidity management involves finding the

right balance of stocks and flows

y Let·s look at a couple of measures that

combine the two

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Current Liquidity IndexCurrent Liquidity Index

Cash assetsCash assets tt--11 + CFFO+ CFFO tt

CLI =CLI = ------------------------------------------------------------------

N/P N/P tt--11 + CMLTD+ CMLTD tt--11

$1,844 + $2,436$1,844 + $2,436

CLI =CLI = ---------------------------------------- = 29.32= 29.32

$146 + $0$146 + $0

1996 1997 1998 19991996 1997 1998 1999

CLICLI 1,755.621,755.62 33.47 85.00 29.3233.47 85.00 29.32

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LambdaLambda

Initial liquid Total anticipated net cash flowInitial 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 the

analysis horizonanalysis horizon

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Financial Flexibility (one measure in text; FitchFinancial Flexibility (one measure in text; Fitch

offers another measure)offers another measure)

Sustainable Growth Rate Concept:Sustainable Growth Rate Concept:

Uses = SourcesUses = Sources

New Assets = New Equity + New DebtNew Assets = New Equity + New Debt

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

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

g* =g* = --------------------------------------------------------------------

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

.0765 x (1.0765 x (1 -- .00) x (1 + 2.3008).00) x (1 + 2.3008)

g*=g*= -------------------------------------------------------------------------------------------------- = 270.49%= 270.49%

.3462.3462 -- [.0765 x (1[.0765 x (1 -- .00)(1 + 2.3008)].00)(1 + 2.3008)]

calculation uses 1998 data to calculate the sustainable 1999 g*.calculation uses 1998 data to calculate the sustainable 1999 g*.

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SummarySummary

y Chapter introduced basic concepts of:

solvency

liquidity

financial flexibility

y Solvency: an accounting concept comparing assets to liabilities

y Liquidity: related to a firm·s ability to pay for its current

obligations in a timely fashion with minimal costs

y Financial flexibility: related to a firm·s overall financial structure

and if financial policies allow firm enough flexibility to takeadvantage of unforeseen opportunities.