Dr. Clive Vlieland-Boddy Liquidity & Leverage Dr. Clive Vlieland-Boddy 1

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Liquidity Ratios WHO CARES? Measure the short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash. WHO CARES? All stakeholders 3

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Proper Debt Structure 5

Monitor Financial Position Measure 6

Monitor Financial Position What Gets Measured Gets Managed and What Gets Managed Gets Done! 7

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 Appreciate capital structure theory 8

Financial Leverage and Risk LEV is the other component of ROE Is Debt a bad thing? Given that increases in financial leverage increase ROE, why are all companies not 100% debt financed? 9

Liquidity and Solvency Measures Liquidity refers to cash: how much we have, how much is expected, and how much can be raised on short notice. Solvency refers to the ability to meet obligations; primarily obligations to creditors, including lessors. 10

Ratios Defined: One number divided by another to express a relationship: Expresses either as- % Ratio of say 2:1 Or in a $ sum say $3 per share. 11

Ratios Be Selective Now is the time to become familiar with financial ratios Select ratios that help focus attention on the most critical areas. Ratio analysis can be done on Historical Current Projected information 12

Balance Sheet Discussion questions Judgments are made based on balance sheets. What is a “good” balance sheet? What is a “good” financial situation? 13

Balance Sheet Analysis To remember. . . Basic equations  Assets = Debt + Equity  Assets minus debts = equity  Assets - equity = debt 14

Liquidity 15

How Liquid Is the Firm? Liquidity measures the firm’s ability to pay its bills on time. It indicates the ease with which non-cash assets can be converted to cash to meet the financial obligations. A liquid asset is one that can be converted quickly and routinely into cash at the current market price. 16

Solvency An accounting concept comparing assets to liabilities. An enterprise is solvent if it can pay its debts as they fall due. Otherwise it is classed as “insolvent” and is either entering bankruptcy or in very difficult situation. 17

Solvency Ratios WHO CARES? Measure the ability of the enterprise to survive over a long period of time WHO CARES? All Stakeholders 18

Financial Flexibility Related to a firm’s overall financial structure and whether financial policies allow firm enough ability to take advantage of unforeseen opportunities. There are always opportunities. If the funds are available then they can be taken. 19

Gearing or Leverage This represents the balance between debt and equity capital. The more debt a company takes on it is becoming more highly geared. 20

Gearing This is an efficiency ratio Looks at the relationship between borrowing and Non Current Assets Gearing Ratio = Long term loans / Capital employed x 100 The higher it is the greater the risk the business is under if interest rates increase 21

Evaluating Liquidity Liquidity is measured by two approaches: Comparing the firm’s current assets and current liabilities Examining the firm’s ability to convert accounts receivables and inventory into cash on a timely basis 22

Analyzing Liquidity 8 Liquidity refers to the solvency of the firm's overall financial position, i.e. a "liquid firm" is one that can easily meet its short-term obligations as they come due. A second meaning includes the concept of converting an asset into cash with little or no loss in value. 23

Analyzing Activity Activity is a more sophisticated analysis of a firm's liquidity Evaluating the speed with which certain accounts are converted into sales or cash. Also measures a firm's efficiency 24

Solvency Measures Cash Ratio Current Ratio Quick Ratio Net Working Capital Net Liquid Balance Working Capital Requirements 25

Measuring Short Term Liquidity Compare a firm’s current assets with current liabilities Cash Ratio Current Ratio Acid Test or Quick Ratio 26

Cash Ratio Indicates short-term debt-paying ability (cash basis) Current Liabilities 27

Cash Ratio Looks at the ability of the enterprise to pay current liabilities just from available cash. It is little used but is useful for companies in real financial difficulty. 28

Current Ratio Current ratio looks at the liquidity of the business Looks at the ratio between Current Assets and Current Liabilities Ideal level – approx 1.5 : 1 (Preferably 2:1) Need enough current assets to cover current liabilities If its too high means too much invested in current assets If its too low you run the risk of not being able to meet current liabilities and could have liquidity problems Buts some industries have a negative Current Ratio like supermarkets. 29

The Current Ratio Current Ratio Balance Sheet Ratios Liquidity Ratios Current Assets Current Liabilities Balance Sheet Ratios Liquidity Ratios Shows a firm’s ability to cover its current liabilities with its current assets. 30

Example 1 Company has Current Assets of $200,000 and Current Liabilities of $100,000 Its Current Ratio would therefore be: 200,000 = 2:1 100,000 31

Financial Leverage Ratio Comparisons-An Example Current Ratio Company Industry 2:1 2:1 2:1 2:1 Year 2010 2009 2008 Company has an average Current Ratio to the industry average. 32

Acid / Quick Ratio Acid test ratio is another way of looking at liquidity It has been argued that stock takes a while to convert to cash so a more realistic ratio would ignore stock (Current assets – stock) : liabilities 1:1 seen as ideal Again if it is too high means that the business is very liquid – may be able to use the cash for other activities to increase performance If it is too low then the business may face working capital problems Some types of business need more cash than others so acid test would be expected to be higher 33

Current Assets - Inventories Acid or Quick Ratio Acid-Test (Quick) Current Assets - Inventories Current Liabilities Balance Sheet Ratios Liquidity Ratios Note that Inventories are deducted as they normally take some months to convert into cash. There may be other Current Assets that need to be included. Shows a firm’s ability to meet current liabilities with its most liquid assets. 34

Example 2 Company has Current Assets of $200,000 of which $80,000 were inventories, and Current Liabilities of $100,000 Its Acid or Quick Ratio would therefore be: 200,000-80,000 = 1.2:1 100,000 35

Financial Leverage Ratio Comparisons-An Example Quick (Acid) Ratio Company Industry 1.2:1 1:1 Year 2010 2009 2008 Company has a higher than average quick Ratio relative to the industry average. 36

Net Working Capital This is the difference between Current Assets and Current Liabilities. Current Assets – Current Liabilities 37

Example 3 Company has Current Assets of $200,000 and Current Liabilities of $100,000 Its Net Working Capital would therefore be: 200,000 -100,000 = 100,000 38

Leverage Ratios 39

Measuring Ability to Pay Debt The debt ratio indicates the proportion of assets financed with debt. Total liabilities ÷ Total assets 40

Financial Leverage Ratios Debt-to-Equity Total Debt Shareholders’ Equity Balance Sheet Ratios Financial Leverage Ratios Shows the extent to which the firm is financed by debt. 41

Example 4 Debt of $900,000 and Equity of $1,000,000 Total Long Term Debt = 900,000 = .9 Total Equity 1,000,000 Assuming that 2009 was .88 and 2009 was .81 then we can compare to the industry. 42

Financial Leverage Ratio Comparisons-An Example Debt-to-Equity Ratio Company Industry .90 .90 .88 .90 .81 .89 Year 2010 2009 2008 Company has average debt utilization relative to the industry average. 43

Financial Leverage Ratios Debt-to-Total-Assets Total Debt Total Assets Balance Sheet Ratios Financial Leverage Ratios Shows the percentage of the firm’s assets that are supported by debt financing. 44

Example 5 Total debt of $900,000 to Total Assets of $2,500,000 Assuming that 2009 was .38 and 2009 was .37 then we can compare to the industry. 45

Financial Leverage Ratio Comparisons-An Example Debt-to-Total-Asset Ratio Company Industry .36 .47 .38 .47 .37 .47 Year 2010 2009 2008 Company has a lower than average debt Utilization relative to the industry average. 46

Financial Leverage Ratios Total Capitalization Total Debt Balance Sheet Ratios (i.e., LT-Debt + Equity) Financial Leverage Ratios Shows the relative importance of long-term debt to the long-term financing both debt and equity of the firm. 47

Example 6 Debt of $900,000 and Equity of $1,000,000 Total Long Term Debt = 900,000 = .47 Total Capitalisation 1,900,000 Assuming that 2009 was .49 and 2009 was .51 then we can compare to the industry. 48

Financial Leverage Ratio Comparisons Total Capitalization Ratio Company Industry .47 .60 .49 .61 .51 .62 Year 2010 2009 2008 The Company has a below average long-term debt Utilization relative to the industry average. 49

Interest Coverage This is an excellent way to assess the ability of an enterprise or even an individual’s ability to service debt. If you bought an apartment for €220k using €200k of loan financing at 5%. If you earnings are €10,000 per annum, you would only be able to pay the interest. In other words once coverage. That is not healthy!. However if you earned €50,000 then it is 5 times covered. 50

Interest Coverage Ratio EBIT Interest Charges Income Statement Ratios Coverage Ratios Indicates a firm’s ability to cover interest charges. 51

Times Interest Earned Ratio (TIE) Is the same as Interest Coverage 52

Example 7 Debt of $900,000 with interest for the year of $70,000 and EBIT of $400,000 EBIT = 400,000 = 5.71 Interest 70,000 Assuming that 2009 was 5.55 and 2009 was 5.51 then we can compare to the industry. 53

Coverage Ratio Comparisons Interest Coverage Ratio Year 2010 2009 2008 Company Industry 5.71 5.19 5.55 5.02 5.51 4.66 The company has a higher but improving Average interest coverage relative to the industry average. 54

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