copyright 1998 by harcourt brace &company chapter 2 analysis of solvency, liquidity, and...

Copyright Copyright 1998 by Harcourt Brace &Company 1998 by Harcourt Brace &Company

Chapter 2Chapter 2Analysis of Solvency, Liquidity, Analysis of Solvency, Liquidity, and Financial Flexibilityand Financial Flexibility

OrderOrder Order Order Sale Sale CashCash PlacedPlaced Received Received ReceivedReceived Accounts CollectionAccounts Collection < Inventory > < Receivable > < Float >< Inventory > < Receivable > < Float >

Time ==>Time ==> Accounts Disbursement Accounts Disbursement

< Payable > < Float >< Payable > < Float > Invoice Invoice Payment Payment CashCash Received Sent Received Sent PaidPaid

OrderOrder Order Order Sale Sale CashCash PlacedPlaced Received Received ReceivedReceived Accounts CollectionAccounts Collection < Inventory > < Receivable > < Float >< Inventory > < Receivable > < Float >

Time ==>Time ==> Accounts Disbursement Accounts Disbursement

< Payable > < Float >< Payable > < Float > Invoice Invoice Payment Payment CashCash Received Sent Received Sent PaidPaid


Learning ObjectivesLearning Objectives

To develop an understanding of liquidityTo develop an understanding of liquidity 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


Financial Statements - Financial Statements - Basic Source of Basic Source of InformationInformation

Balance SheetBalance Sheet

Income StatementIncome Statement

Statement of Cash FlowsStatement of Cash Flows


Solvency MeasuresSolvency Measures

Current RatioCurrent Ratio

Quick RatioQuick Ratio

Net Working CapitalNet Working Capital

Net Liquid BalanceNet Liquid Balance

Working Capital RequirementsWorking Capital Requirements


Current RatioCurrent Ratio

Current assetsCurrent assetsCurrent ratio = -------------------------Current ratio = ------------------------- Current liabilitiesCurrent liabilities

$15,338$15,338Current ratio = ------------ = 1.54Current ratio = ------------ = 1.54 $9,973$9,973

19911991 1992 1992 1993 1994 1995 1993 1994 1995Current ratioCurrent ratio 1.61 1.61 1.71 1.71 1.51 1.64 1.54 1.51 1.64 1.54

Current assetsCurrent assetsCurrent ratio = -------------------------Current ratio = ------------------------- Current liabilitiesCurrent liabilities

$15,338$15,338Current ratio = ------------ = 1.54Current ratio = ------------ = 1.54 $9,973$9,973

19911991 1992 1992 1993 1994 1995 1993 1994 1995Current ratioCurrent ratio 1.61 1.61 1.71 1.71 1.51 1.64 1.54 1.51 1.64 1.54


Quick RatioQuick Ratio

Current assets - InventoriesCurrent assets - InventoriesQuick ratio = -------------------------------------Quick ratio = ------------------------------------- Current liabilitiesCurrent liabilities

$15,338 - $14,064$15,338 - $14,064Quick ratio = ------------------------ = .13Quick ratio = ------------------------ = .13 $9,973$9,973

19911991 1992 1992 1993 1994 1995 1993 1994 1995Quick ratioQuick ratio .15 .15 .24 .24 .14 .15 .13 .14 .15 .13

Current assets - InventoriesCurrent assets - InventoriesQuick ratio = -------------------------------------Quick ratio = ------------------------------------- Current liabilitiesCurrent liabilities

$15,338 - $14,064$15,338 - $14,064Quick ratio = ------------------------ = .13Quick ratio = ------------------------ = .13 $9,973$9,973

19911991 1992 1992 1993 1994 1995 1993 1994 1995Quick ratioQuick ratio .15 .15 .24 .24 .14 .15 .13 .14 .15 .13


Net Working CapitalNet Working Capital

Net working capital = CA - CLNet working capital = CA - CL

Net working capital = $15,338 - $9,973Net working capital = $15,338 - $9,973 = $5,365= $5,365

($000,000)($000,000) 1991 1992 1993 1994 1995 1991 1992 1993 1994 1995Net working capital $2,425 $3,571 $3,444 $4,709 $5,365 Net working capital $2,425 $3,571 $3,444 $4,709 $5,365

Grant’s NWC averaged about $371 million Grant’s NWC averaged about $371 million

Net working capital = CA - CLNet working capital = CA - CL

Net working capital = $15,338 - $9,973Net working capital = $15,338 - $9,973 = $5,365= $5,365

($000,000)($000,000) 1991 1992 1993 1994 1995 1991 1992 1993 1994 1995Net working capital $2,425 $3,571 $3,444 $4,709 $5,365 Net working capital $2,425 $3,571 $3,444 $4,709 $5,365

Grant’s NWC averaged about $371 million Grant’s NWC averaged about $371 million


NWC and its Component NWC and its Component PartsParts

CashCash

Mkt SecMkt Sec

A/RA/R

InventoryInventory

PrepaidPrepaid

A/PA/P

N/PN/P

CMLTDCMLTD

CashCash

Mkt SecMkt Sec

A/RA/R

InventoryInventory

PrepaidPrepaid

A/PA/P

N/PN/P

CMLTDCMLTD

CashCash

Mkt SecMkt Sec

A/RA/R

InventoryInventory

PrepaidPrepaid

A/PA/P

N/PN/P

CMLTDCMLTD

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


Working Capital Working Capital RequirementsRequirements

($900+$14,064+$329) - ($5,907+$365+$1,819)($900+$14,064+$329) - ($5,907+$365+$1,819)WCR/S = -----------------------------------------------------------WCR/S = -----------------------------------------------------------

$82,494$82,494

$7,202$7,202 = ----------- = .09= ----------- = .09

$82,494$82,494

1991 1992 1993 1994 19951991 1992 1993 1994 1995WCR/S .09 .09 .09 .10 .09WCR/S .09 .09 .09 .10 .09

Grant’s WCR/S ratio averaged .42Grant’s WCR/S ratio averaged .42

($900+$14,064+$329) - ($5,907+$365+$1,819)($900+$14,064+$329) - ($5,907+$365+$1,819)WCR/S = -----------------------------------------------------------WCR/S = -----------------------------------------------------------

$82,494$82,494

$7,202$7,202 = ----------- = .09= ----------- = .09

$82,494$82,494

1991 1992 1993 1994 19951991 1992 1993 1994 1995WCR/S .09 .09 .09 .10 .09WCR/S .09 .09 .09 .10 .09

Grant’s WCR/S ratio averaged .42Grant’s WCR/S ratio averaged .42


Net Liquid BalanceNet Liquid Balance

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

Net liquid balance = $45 - ($1,795 + $87)Net liquid balance = $45 - ($1,795 + $87) = ($1,837)= ($1,837)

($000,000)($000,000) 1991 1992 1993 1994 1995 1991 1992 1993 1994 1995Net liquid balance ($413) ($463) ($1,636) ($1,626) ($1,837)Net liquid balance ($413) ($463) ($1,636) ($1,626) ($1,837)

Grant’s NLB ran at a deficitGrant’s NLB ran at a deficit

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

Net liquid balance = $45 - ($1,795 + $87)Net liquid balance = $45 - ($1,795 + $87) = ($1,837)= ($1,837)

($000,000)($000,000) 1991 1992 1993 1994 1995 1991 1992 1993 1994 1995Net liquid balance ($413) ($463) ($1,636) ($1,626) ($1,837)Net liquid balance ($413) ($463) ($1,636) ($1,626) ($1,837)

Grant’s NLB ran at a deficitGrant’s NLB ran at a deficit


What is Liquidity?What is Liquidity?

IngredientsIngredients– TimeTime

– AmountAmount

– CostCost

DefinitionDefinition– Having enough financial resources to cover financial Having enough financial resources to cover financial

obligations in a timely manner with minimal costsobligations in a timely manner with minimal costs


What is Liquidity - What is Liquidity - Examples (Ludeman)Examples (Ludeman)

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


Liquidity MeasuresLiquidity Measures

Cash Flow From OperationsCash Flow From Operations (narrow) (narrow)

Cash Conversion PeriodCash Conversion Period(narrow)(narrow)

Current Liquidity IndexCurrent Liquidity Index(narrow)(narrow)

LambdaLambda(broad)(broad)


Cash Flow From Cash Flow From OperationsOperations

($ Billions) 1991 1992 1993 1994 1995($ Billions) 1991 1992 1993 1994 1995CFFO or OCF $1.29 $1.37 $1.27 $2.19 $2.91CFFO or OCF $1.29 $1.37 $1.27 $2.19 $2.91

W.T. Grant’s CFFO was a deficit for 8 of its last 10 years.W.T. Grant’s CFFO was a deficit for 8 of its last 10 years.

($ Billions) 1991 1992 1993 1994 1995($ Billions) 1991 1992 1993 1994 1995CFFO or OCF $1.29 $1.37 $1.27 $2.19 $2.91CFFO or OCF $1.29 $1.37 $1.27 $2.19 $2.91

W.T. Grant’s CFFO was a deficit for 8 of its last 10 years.W.T. Grant’s CFFO was a deficit for 8 of its last 10 years.

Wal - Mart’s Cash Flow From OperationsWal - Mart’s Cash Flow From Operations


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


Cash Conversion Period Cash Conversion Period Calculations (Wal-Mart)Calculations (Wal-Mart)

Cash conversion period = DIH + DSO - DPOCash conversion period = DIH + DSO - DPO

(Days) (Days) 1991 1992 1993 1994 19951991 1992 1993 1994 1995DIHDIH 84.02 78.55 77.68 76.40 79.57 84.02 78.55 77.68 76.40 79.57DSO 6.10 9.15 5.51 4.87 3.98DSO 6.10 9.15 5.51 4.87 3.98 ------- ------ ------ ------ ------------- ------ ------ ------ ------Operating cycleOperating cycle 90.12 87.70 83.19 81.27 83.55 90.12 87.70 83.19 81.27 83.55DPODPO 38.46 36.74 32.46 28.47 33.42 38.46 36.74 32.46 28.47 33.42

------- ------- ------- ------- -------------- ------- ------- ------- -------Cash conversion period 51.66 50.96 50.73 52.80 50.13Cash conversion period 51.66 50.96 50.73 52.80 50.13

Grant’s cash conversion period exceeded 200 days!Grant’s cash conversion period exceeded 200 days!

Cash conversion period = DIH + DSO - DPOCash conversion period = DIH + DSO - DPO

(Days) (Days) 1991 1992 1993 1994 19951991 1992 1993 1994 1995DIHDIH 84.02 78.55 77.68 76.40 79.57 84.02 78.55 77.68 76.40 79.57DSO 6.10 9.15 5.51 4.87 3.98DSO 6.10 9.15 5.51 4.87 3.98 ------- ------ ------ ------ ------------- ------ ------ ------ ------Operating cycleOperating cycle 90.12 87.70 83.19 81.27 83.55 90.12 87.70 83.19 81.27 83.55DPODPO 38.46 36.74 32.46 28.47 33.42 38.46 36.74 32.46 28.47 33.42

------- ------- ------- ------- -------------- ------- ------- ------- -------Cash conversion period 51.66 50.96 50.73 52.80 50.13Cash conversion period 51.66 50.96 50.73 52.80 50.13

Grant’s cash conversion period exceeded 200 days!Grant’s cash conversion period exceeded 200 days!


How Much Liquidity is How Much Liquidity is Enough?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


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

$20 + $2,906$20 + $2,906CLI = ------------------ = 1.78CLI = ------------------ = 1.78

$1,575 + $71$1,575 + $71

1992 1993 1994 19951992 1993 1994 1995CLI CLI 3.21 3.21 2.65 1.34 1.78 2.65 1.34 1.78

W.T. Grant’s current liquidity index ran at a deficit.W.T. Grant’s current liquidity index ran at a deficit.

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

$20 + $2,906$20 + $2,906CLI = ------------------ = 1.78CLI = ------------------ = 1.78

$1,575 + $71$1,575 + $71

1992 1993 1994 19951992 1993 1994 1995CLI CLI 3.21 3.21 2.65 1.34 1.78 2.65 1.34 1.78

W.T. Grant’s current liquidity index ran at a deficit.W.T. Grant’s current liquidity index ran at a deficit.


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

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


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)]}

.0346 x (1 - .1282) x (1 + 1.4590).0346 x (1 - .1282) x (1 + 1.4590) g = ------------------------------------------------- = 23.30%g = ------------------------------------------------- = 23.30% .3926 - [.0346 x (1 - .1282)(1 + 1.4590)].3926 - [.0346 x (1 - .1282)(1 + 1.4590)]calculation uses 1994 data to calculate the sustainable 1995 g.calculation uses 1994 data to calculate the sustainable 1995 g.

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)]}

.0346 x (1 - .1282) x (1 + 1.4590).0346 x (1 - .1282) x (1 + 1.4590) g = ------------------------------------------------- = 23.30%g = ------------------------------------------------- = 23.30% .3926 - [.0346 x (1 - .1282)(1 + 1.4590)].3926 - [.0346 x (1 - .1282)(1 + 1.4590)]calculation uses 1994 data to calculate the sustainable 1995 g.calculation uses 1994 data to calculate the sustainable 1995 g.


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 : related to a firm’s ability to pay for its current obligations in a timely fashion with minimal current obligations in a timely fashion with minimal costscosts

Financial flexibilityFinancial flexibility: related to a firm’s overall financial : related to a firm’s overall financial structure and if financial policies allows firm enough structure and if financial policies allows firm enough flexibility to take advantage of unforeseen opportunities.flexibility to take advantage of unforeseen opportunities.

copyright 1998 by harcourt brace &company chapter 2 analysis of solvency, liquidity, and...

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