Copyright  2005 by Thomson Learning, Inc. Chapter 2 Analysis of Solvency, Liquidity, and Financial Flexibility Order Order Sale Payment Sent Cash Placed Received Received Accounts Collection Accounts Collection Time ==> Time ==> Accounts Disbursement Accounts Disbursement Invoice Received Payment Sent Cash Disbursed Invoice Received Payment Sent Cash Disbursed Order Order Sale Payment Sent Cash Placed Received Received Accounts Collection Accounts Collection Time ==> Time ==> Accounts Disbursement Accounts Disbursement Invoice Received Payment Sent Cash Disbursed Invoice Received 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 assets Current ratio = Current liabilities Current liabilities $8,924 $8,924 Current ratio = = 1.00 $8,933 $8, Current ratio Current assets Current assets Current ratio = Current liabilities Current liabilities $8,924 $8,924 Current ratio = = 1.00 $8,933 $8, Current ratio

Copyright  2005 by Thomson Learning, Inc. Quick Ratio Current assets - Inventories Current assets - Inventories Quick ratio = Current liabilities Current liabilities $8,924 - $306 $8,924 - $306 Quick ratio = =.96 $8,933 $8, Quick ratio Current assets - Inventories Current assets - Inventories Quick ratio = Current liabilities Current liabilities $8,924 - $306 $8,924 - $306 Quick ratio = =.96 $8,933 $8, Quick ratio

Copyright  2005 by Thomson Learning, Inc. Net Working Capital Net working capital = CA - CL Net working capital = $8,924 - $8,933 = ($9) = ($9) ($000,000) Net working capital $2,644 $2,489 $2,948 $358 ($9) Net working capital = CA - CL Net working capital = $8,924 - $8,933 = ($9) = ($9) ($000,000) Net working capital $2,644 $2,489 $2,948 $358 ($9)

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

Copyright  2005 by Thomson Learning, Inc. Working Capital Requirements ($2,586+$306+$1,394) - ($5,989+$54+$1,458+$1,432) ($2,586+$306+$1,394) - ($5,989+$54+$1,458+$1,432) WCR/S = $35,404 $35,404($4,647) = = = = $35,404 $35, WCR/S ($2,586+$306+$1,394) - ($5,989+$54+$1,458+$1,432) ($2,586+$306+$1,394) - ($5,989+$54+$1,458+$1,432) WCR/S = $35,404 $35,404($4,647) = = = = $35,404 $35, WCR/S

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 = $4,638 ($000,000) Net liquid balance $3,181 $4,132 $5,438 $3,914 $4,638 Net liquid balance = Cash + Equiv. - (N/P + CMLTD) Net liquid balance = $4,638 - ($0) = $4,638 = $4,638 ($000,000) Net liquid balance $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 $2,436 $3,926 $4,195 $3,797 $3,538 ($ 000,000) CFFO $2,436 $3,926 $4,195 $3,797 $3,538

Copyright  2005 by Thomson Learning, Inc. Cash Conversion Efficiency ($ 000,000) CFFO $2,436 $3,926 $4,195 $3,797 $3,538 Revenues 18,243 25,265 31,888 31,168 35,404 Operating profit 2,046 2,457 2,768 2,271 2,844 Net profit 1,460 1,666 2,177 1,246 2,122 (Percentage of sales) Operating profit margin Net profit margin Cash conversion efficiency Cash conversion efficient = CFFO / Sales ($ 000,000) CFFO $2,436 $3,926 $4,195 $3,797 $3,538 Revenues 18,243 25,265 31,888 31,168 35,404 Operating profit 2,046 2,457 2,768 2,271 2,844 Net profit 1,460 1,666 2,177 1,246 2,122 (Percentage of sales) Operating profit margin Net profit margin Cash conversion efficiency Cash conversion efficient = CFFO / Sales

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

Copyright  2005 by Thomson Learning, Inc. Cash Conversion Period Calculations Cash conversion period = DIH + DSO - DPO (Days) DIH DSO Operating cycle DPO Cash conversion period Cash conversion period = DIH + DSO - DPO (Days) DIH DSO Operating cycle DPO Cash conversion period

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 Cash assets t-1 + CFFO t CLI = N/P t-1 + CMLTD t-1 N/P t-1 + CMLTD t-1 $4,638 + $3,538 $4,638 + $3,538 CLI = = infinite $0 + $0 $0 + $0 Cash assets t-1 + CFFO t Cash assets t-1 + CFFO t CLI = N/P t-1 + CMLTD t-1 N/P t-1 + CMLTD t-1 $4,638 + $3,538 $4,638 + $3,538 CLI = = infinite $0 + $0 $0 + $0

Copyright  2005 by Thomson Learning, Inc. Lambda Initial liquid Total anticipated net cash flow Initial liquid Total anticipated net cash flow reserve + during the analysis horizon Lambda = Uncertainty about the net cash flow during the analysis horizon Initial liquid Total anticipated net cash flow 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: Sustainable Growth Rate Concept: Uses = Sources Uses = Sources New 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)]} x ( ) x ( ) x ( ) x ( ) g = = 36.14% g = = 36.14% [ x ( )( )] [ x ( )( )] calculation uses 2002 data to calculate the sustainable 2003 g. Sustainable Growth Rate Concept: Sustainable Growth Rate Concept: Uses = Sources Uses = Sources New 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)]} x ( ) x ( ) x ( ) x ( ) g = = 36.14% g = = 36.14% [ x ( )( )] [ x ( )( )] calculation uses 2002 data to calculate the sustainable 2003 g.

Copyright  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.