Chapter 2 Analysis of Solvency, Liquidity, and Financial Flexibility
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Copyright Copyright 2002 by South-Western, a division of 2002 by South-Western, a division of Thomson Learning Thomson Learning TM TM Chapter 2 Chapter 2 Analysis of Solvency, Liquidity, Analysis of Solvency, Liquidity, and Financial Flexibility and Financial Flexibility Order Order Order Order Sale Sale Placed Placed Received Received < Inventory > < Receivable < Inventory > < Receivable Accounts Disbursement Accounts Disbursement < Payable > < Float < Payable > < Float Invoice Invoice Received Sent Received Sent
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Chapter 2 Analysis of Solvency, Liquidity, and Financial Flexibility. Order Order Sale Cash Placed Received Received Accounts Collection - PowerPoint PPT Presentation
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Chapter 2Chapter 2Analysis of Solvency, Liquidity, and Analysis of Solvency, Liquidity, and Financial FlexibilityFinancial Flexibility
OrderOrder Order Order Sale Sale CashCash PlacedPlaced Received Received ReceivedReceived Accounts CollectionAccounts Collection < Inventory > < Receivable > < Float >< Inventory > < Receivable > < Float >
Accounts Disbursement Accounts Disbursement Time ==>Time ==>< Payable > < Float > < Payable > < Float >
Invoice Invoice Payment Payment CashCash Received Sent Received Sent PaidPaid
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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
$6,339$6,339Current ratio = ----------- = 1.72Current ratio = ----------- = 1.72 $3,695$3,695
19951995 1996 1996 1997 1998 1999 1997 1998 1999Current ratioCurrent ratio 1.96 1.96 2.08 2.08 1.66 1.45 1.72 1.66 1.45 1.72
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Quick RatioQuick Ratio
Current assets - InventoriesCurrent assets - InventoriesQuick ratio = -------------------------------------Quick ratio = ------------------------------------- Current liabilitiesCurrent liabilities
$6,339 - $273$6,339 - $273Quick ratio = -------------------- = 1.64Quick ratio = -------------------- = 1.64 $3,695$3,695
19951995 1996 1996 1997 1998 1999 1997 1998 1999Quick ratioQuick ratio 1.57 1.57 1.63 1.63 1.51 1.36 1.64 1.51 1.36 1.64
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Net Working CapitalNet Working Capital
Net working capital = CA - CLNet working capital = CA - CL
Net working capital = $6,339 - $3,695Net working capital = $6,339 - $3,695 = $2,644= $2,644
($ Millions)($ Millions) 1995 1996 1997 1998 1999 1995 1996 1997 1998 1999Net working capital $ 719 $1,018 $1,089 $1,215 $2,644 Net 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/RA/R
InventoryInventory
PrepaidPrepaid
N/PN/P
CashCash
Mkt SecMkt Sec
A/RA/R
InventoryInventory
PrepaidPrepaid
CashCash
Mkt SecMkt Sec
A/RA/R
InventoryInventory
PrepaidPrepaid
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
A/PA/P A/PA/P A/PA/P
N/PN/P
CMLTDCMLTD
N/PN/P
CMLTDCMLTDCMLTDCMLTD
AccrualsAccruals AccruaAccrualsls
AccrualsAccruals
- Accruals- Accruals
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Working Capital RequirementsWorking Capital Requirements
($2,481+$273+$404) - ($2,397+$355+$943)($2,481+$273+$404) - ($2,397+$355+$943)WCR/S = -----------------------------------------------------------WCR/S = -----------------------------------------------------------
$18,243$18,243
($537)($537) = ----------- = -0.029= ----------- = -0.029
$18,243$18,243
1995 1996 1997 1998 19991995 1996 1997 1998 1999WCR/S .055 .082 -.030 -.039 -.029WCR/S .055 .082 -.030 -.039 -.029
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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 = $3,181 - $0Net liquid balance = $3,181 - $0 = $3,181 = $3,181
($ Millions)($ Millions) 1995 1996 1997 1998 1999 1995 1996 1997 1998 1999Net liquid balance $527 $586 $1,325 $1,698 $3,181Net liquid balance $527 $586 $1,325 $1,698 $3,181
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What is Liquidity?What is Liquidity?
IngredientsIngredients– TimeTime– AmountAmount– CostCost
DefinitionDefinition– Having enough financial resources to cover financial obligations Having enough financial resources to cover financial obligations
in a timely manner with minimal costsin a timely manner with minimal costs
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What is Liquidity - ExamplesWhat is Liquidity - Examples
Amount and trend of internal cash flowAmount and trend of internal cash flow
Aggregate available credit linesAggregate available credit lines
Attractiveness of firm’s commercial paper and Attractiveness of firm’s commercial paper and other financial instrumentsother financial instruments
Overall expertise of managementOverall expertise of management
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Liquidity MeasuresLiquidity Measures
Cash Flow From OperationsCash Flow From Operations
Cash Conversion PeriodCash Conversion Period
Current Liquidity IndexCurrent Liquidity Index
LambdaLambda
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Cash Flow From OperationsCash Flow From Operations
($ Millions) 1995 1996 1997 1998 1999($ Millions) 1995 1996 1997 1998 1999CFFO $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 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) 1995 1996 1997 1998 1999(Days) 1995 1996 1997 1998 1999DIHDIH 40 37 15 9 7 40 37 15 9 7 DSO 57 50 42 44 50 DSO 57 50 42 44 50 ------- ------ ------ ------ ------------- ------ ------ ------ ------Operating cycleOperating cycle 97 87 57 53 57 97 87 57 53 57DPODPO 60 41 63 63 62 60 41 63 63 62
------- ------- ------- ------- -------------- ------- ------- ------- -------Cash conversion period 37 46 -6 -10 -5Cash conversion period 37 46 -6 -10 -5
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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
$1,844 + $2,436$1,844 + $2,436CLI = -------------------- = 29.32CLI = -------------------- = 29.32
$146 + $0$146 + $0
1996 1997 1998 19991996 1997 1998 1999CLI CLI 1,755.62 1,755.62 33.47 85.00 29.32 33.47 85.00 29.32
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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
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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)]}
.0765 x (1 - .00) x (1 + 2.3008).0765 x (1 - .00) x (1 + 2.3008) g = ------------------------------------------------- = 270.49%g = ------------------------------------------------- = 270.49% .3462 - [.0765 x (1 - .00)(1 + 2.3008)].3462 - [.0765 x (1 - .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
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 liabilitiesliabilities
LiquidityLiquidity: related to a firm’s ability to pay for its current : related to a firm’s ability to pay for its current obligations in a timely fashion with minimal costsobligations in a timely fashion with minimal costs
Financial flexibilityFinancial flexibility: related to a firm’s overall financial : related to a firm’s overall financial structure and if financial policies allow firm enough structure and if financial policies allow firm enough flexibility to take advantage of unforeseen opportunities.flexibility to take advantage of unforeseen opportunities.
