Transcript Chapter 7: Liquidity Analysis and Financial Flexibility

Chapter 2
Analysis of Solvency, Liquidity, and
Financial Flexibility
Order
Placed
Order
Received
< Inventory >
Sale
Payment Sent Cash
Received
Accounts
Collection
< Receivable > < Float >
Time ==>
Accounts
< Payable >
Invoice Received
Disbursement
<
Float
>
Payment Sent
Cash Disbursed
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Learning Objectives
Differentiate between solvency and liquidity ratios
 Conduct a liquidity analysis
 Assess a firm’s financial flexibility position
 Consider a firm’s liquidity, broadly defined, as a
combination of its solvency, liquidity, and
financial flexibility

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Financial Statements –
Basic Source of Information

Balance Sheet

Income Statement

Statement of Cash Flows
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Solvency Measures

Current Ratio

Quick Ratio

Net Working Capital

Net Liquid Balance

Working Capital Requirements
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Current Ratio
Current assets
Current ratio = ------------------------Current liabilities
$8,924
Current ratio = ------------ = 1.00 x
$8,933
Current ratio
1999
1.72
2000
1.48
2001
1.45
2002
1.05
2003
1.00
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Quick Ratio
Current assets - Inventories
Quick ratio = ------------------------------------Current liabilities
$8,924 - $306
Quick ratio = ------------------- = 0.96 x
$8,933
Quick ratio
1999
1.64
2000
1.40
2001
1.39
2002
1.01
2003
0.96
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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)
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NWC and its Component Parts
CA
CL
CA
CL
CA
Cash
Cash
Cash
Mkt Sec
Mkt Sec
Mkt Sec
CL
A/R
A/P
A/R
A/P
A/R
A/P
Inventory
N/P
Inventory
N/P
Inventory
N/P
Prepaid
CMLTD
Prepaid
CMLTD
Prepaid
CMLTD
NWC = CA - CL
Net Working Capital
WCR = A/R + INV +Pre
- A/P
=
Working Capital Requirements
NLB = Cash + M/S
- N/P - CMLTD
+
Net Liquid Balance
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Working Capital Requirements
($2,586+$306+$1,394) - ($5,989+$54+$1,458+$1,432)
WCR/S = ------------------------------------------------------------------$35,404
=
WCR/S
($4,647)
---------- = -0.1313
$35,404
1999
2000
2001
2002
2003
- 0.029 -0.065 -0.078 -0.114 -0.131
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Net Liquid Balance
Net liquid balance = Cash & M.S. - (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 $4,638
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What is Liquidity?

Ingredients
– Time
– Amount
– Cost

Definition
– Having enough financial resources to cover financial obligations
in a timely manner with minimal costs
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What is Liquidity - Examples

Amount and trend of internal cash flow

Aggregate available credit lines

Attractiveness of firm’s commercial paper and
other financial instruments

Overall expertise of management
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Liquidity Measures

Cash Flow From Operations

Cash Conversion Efficiency

Cash Conversion Period

Current Liquidity Index

Lambda
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Cash Flow From Operations
($ 000,000)
CFFO
1999
2000
2001
2002
2003
$2,436 $3,926 $4,195 $3,797 $3,538
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Cash Conversion Efficiency
($ 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 11.21
Net profit margin
8.00
Cash conversion efficiency 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 efficiency = CFFO / Sales
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Cash Conversion Chart
Inventory
stocked
Inventory
sold
Days inventory held
Days payables outstanding
Cash
received
Days sales outstanding
Cash conversion
period
Cash
disbursed
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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
(Days)
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How Much Liquidity is Enough?

Solvency - a stock or balance perspective

Liquidity - a flow perspective

Liquidity management involves finding the right
balance of stocks and flows
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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
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Lambda
Initial liquid Total anticipated net cash flow
reserve
+ during the analysis horizon
Lambda = ------------------------------------------------------------------Uncertainty about the net cash flow during the
analysis horizon
Where initial liquid reserve includes cash,
marketable securities, and unused ST debt
capacity
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Financial Flexibility
Sustainable Growth Rate Concept:
Uses
New Assets
gS(A/S)
=
Sources
= New Equity + New Debt
= m(S+gS)(1-d) + m(S+gS)(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 calculateCopyright
the sustainable
2003 g.
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Summary

Chapter 2 introduced basic concepts of:
– solvency
– liquidity
– financial flexibility
Solvency: an accounting concept comparing assets
to liabilities.
 Liquidity: related to a firm’s ability to pay for its
current obligations in a timely fashion with
minimal costs.
 Financial flexibility: related to a firm’s overall
financial structure and whether financial policies
allow firm enough flexibility to take advantage of
unforeseen opportunities.

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