Chapter 2 Analysis of Solvency Liquidity and Financial

Chapter 2 Analysis of Solvency, Liquidity, and Financial Flexibility Order Placed Order Received Sale Payment Sent Cash Received Accounts Collection < Inventory > < Receivable > < Float > Time ==> Accounts < Payable > Invoice Received Disbursement < Float > Payment Sent Cash Disbursed Copyright 2005 by Thomson Learning, Inc.

Learning Objectives v Differentiate between solvency and liquidity ratios v Conduct a liquidity analysis v Assess a firm’s financial flexibility position Copyright 2005 by Thomson Learning, Inc.

Financial Statements - Basic Source of Information v Balance Sheet v Income Statement v Statement of Cash Flows Copyright 2005 by Thomson Learning, Inc.

Solvency Measures v Current Ratio v Quick Ratio v Net Working Capital v Net Liquid Balance v Working Capital Requirements Copyright 2005 by Thomson Learning, Inc.

Current Ratio Current assets Current ratio = ------------Current liabilities $8, 924 Current ratio = ------ = 1. 00 $8, 933 Current ratio 1999 1. 72 2000 1. 48 2001 1. 45 2002 1. 05 2003 1. 00 Copyright 2005 by Thomson Learning, Inc.

Quick Ratio Current assets - Inventories Quick ratio = ------------------Current liabilities $8, 924 - $306 Quick ratio = ---------- =. 96 $8, 933 Quick ratio 1999 1. 64 2000 1. 40 2001 1. 39 2002 1. 01 2003 0. 96 Copyright 2005 by Thomson Learning, Inc.

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) Copyright 2005 by Thomson Learning, Inc.

NWC and its Component Parts CA CL CA Cash Mkt Sec CL A/R A/P Inventory N/P Prepaid CMLTD NWC = CA - CL Net Working Capital WCR = A/R + INV +Pre - A/P Working Capital Requirements Copyright NLB = Cash + M/S - N/P - CMLTD Net Liquid Balance Netby. Liquid 2005 Thomson Balance Learning, Inc.

Working Capital Requirements ($2, 586+$306+$1, 394) - ($5, 989+$54+$1, 458+$1, 432) WCR/S = ---------------------------------$35, 404 = WCR/S ($4, 647) ----- = -. 1313 $35, 404 1999 2000 2001 2002 2003 - 0. 029 -0. 065 -0. 078 -0. 114 -0. 131 Copyright 2005 by Thomson Learning, Inc.

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 Copyright 2005 by Thomson Learning, Inc.

What is Liquidity? v Ingredients – Time – Amount – Cost v Definition – Having enough financial resources to cover financial obligations in a timely manner with minimal costs Copyright 2005 by Thomson Learning, Inc.

What is Liquidity - Examples v Amount and trend of internal cash flow v Aggregate available credit lines v Attractiveness of firm’s commercial paper and other financial instruments v Overall expertise of management Copyright 2005 by Thomson Learning, Inc.

Liquidity Measures v Cash Flow From Operations v Cash Conversion Efficiency v Cash Conversion Period v Current Liquidity Index v Lambda Copyright 2005 by Thomson Learning, Inc.

Cash Flow From Operations ($ 000, 000) CFFO 1999 2000 2001 2002 2003 $2, 436 $3, 926 $4, 195 $3, 797 $3, 538 Copyright 2005 by Thomson Learning, Inc.

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 Net profit margin Cash conversion efficiency 11. 21 8. 00 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 Copyright 2005 by Thomson Learning, Inc.

Cash Conversion Chart Inventory stocked Inventory sold Days inventory held Days payables outstanding Cash received Days sales outstanding Cash conversion period Cash disbursed Copyright 2005 by Thomson Learning, Inc.

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 Copyright 2005 by Thomson Learning, Inc.

How Much Liquidity is Enough? v Solvency - a stock or balance perspective v Liquidity - a flow perspective v Liquidity management involves finding the right balance of stocks and flows Copyright 2005 by Thomson Learning, Inc.

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 Copyright 2005 by Thomson Learning, Inc.

Lambda Initial liquid Total anticipated net cash flow reserve + during the analysis horizon Lambda = ---------------------------------Uncertainty about the net cash flow during the analysis horizon Copyright 2005 by Thomson Learning, Inc.

Financial Flexibility Sustainable Growth Rate Concept: Uses New Assets g. S(A/S) = Sources = New Equity + New Debt = m(S+g. S)(1 -d) + m(S+g. S)(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. Copyright the sustainable 2003 g. 2005 by Thomson Learning, Inc.

Summary v Chapter introduced basic concepts of: – solvency – liquidity – financial flexibility v Solvency: an accounting concept comparing assets to liabilities. v Liquidity: related to a firm’s ability to pay for its current obligations in a timely fashion with minimal costs. v Financial flexibility: related to a firm’s overall financial structure and if financial policies allows firm enough flexibility to take advantage of unforeseen opportunities. Copyright 2005 by Thomson Learning, Inc.