1. 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

2. 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

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

4. 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

5. 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 $8,933 1999 2000 2001 2002 2003 1999 2000 2001 2002 2003 Current ratio 1.72 1.48 1.45 1.05 1.00 Current assets Current assets Current ratio = ------------------------- Current liabilities Current liabilities $8,924 $8,924 Current ratio = ------------ = 1.00 $8,933 $8,933 1999 2000 2001 2002 2003 1999 2000 2001 2002 2003 Current ratio 1.72 1.48 1.45 1.05 1.00

6. 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 $8,933 1999 2000 2001 2002 2003 1999 2000 2001 2002 2003 Quick ratio 1.64 1.40 1.39 1.01 0.96 Current assets - Inventories Current assets - Inventories Quick ratio = ------------------------------------- Current liabilities Current liabilities $8,924 - $306 $8,924 - $306 Quick ratio = ------------------- =.96 $8,933 $8,933 1999 2000 2001 2002 2003 1999 2000 2001 2002 2003 Quick ratio 1.64 1.40 1.39 1.01 0.96

7. 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) 1999 2000 2001 2002 2003 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) 1999 2000 2001 2002 2003 Net working capital $2,644 $2,489 $2,948 $358 ($9)

8. 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

9. 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) = ---------- = -.1313 = ---------- = -.1313 $35,404 $35,404 1999 2000 2001 2002 2003 1999 2000 2001 2002 2003 WCR/S - 0.029 -0.065 -0.078 -0.114 -0.131 ($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) = ---------- = -.1313 = ---------- = -.1313 $35,404 $35,404 1999 2000 2001 2002 2003 1999 2000 2001 2002 2003 WCR/S - 0.029 -0.065 -0.078 -0.114 -0.131

10. 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) 1999 2000 2001 2002 2003 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) 1999 2000 2001 2002 2003 Net liquid balance $3,181 $4,132 $5,438 $3,914 $4,638

11. 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

12. 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

13. 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

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

15. Copyright  2005 by Thomson Learning, Inc. Cash Conversion Efficiency ($ 000,000) 1999 2000 2001 2002 2003 CFFO $2,436 $3,926 $4,195 $3,797 $3,538 Revenues 18,243 25,265 31,888 31,168 35,404 Operating profit 2,046 2,457 2,768 2,271 2,844 Net profit 1,460 1,666 2,177 1,246 2,122 (Percentage of sales) Operating profit margin 11.21 9.72 8.68 7.28 8.03 Net profit margin 8.00 6.59 6.82 3.99 5.99 Cash conversion efficiency 13.35 15.54 13.15 12.18 9.99 Cash conversion efficient = CFFO / Sales ($ 000,000) 1999 2000 2001 2002 2003 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 11.21 9.72 8.68 7.28 8.03 Net profit margin 8.00 6.59 6.82 3.99 5.99 Cash conversion efficiency 13.35 15.54 13.15 12.18 9.99 Cash conversion efficient = CFFO / Sales

16. 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

17. Copyright  2005 by Thomson Learning, Inc. Cash Conversion Period Calculations Cash conversion period = DIH + DSO - DPO (Days) 1999 2000 2001 2002 2003 DIH 7.10 7.17 5.79 3.99 3.87 DSO 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 Cash conversion period = DIH + DSO - DPO (Days) 1999 2000 2001 2002 2003 DIH 7.10 7.17 5.79 3.99 3.87 DSO 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

18. 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

19. 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

20. 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

21. 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)]}.039977 x (1 - 0.00) x (1 + 1.8834).039977 x (1 - 0.00) x (1 + 1.8834) g = ----------------------------------------------------- = 36.14% g = ----------------------------------------------------- = 36.14%.43426 - [0.039977 x (1 - 0.00)(1 + 1.8834)].43426 - [0.039977 x (1 - 0.00)(1 + 1.8834)] 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)]}.039977 x (1 - 0.00) x (1 + 1.8834).039977 x (1 - 0.00) x (1 + 1.8834) g = ----------------------------------------------------- = 36.14% g = ----------------------------------------------------- = 36.14%.43426 - [0.039977 x (1 - 0.00)(1 + 1.8834)].43426 - [0.039977 x (1 - 0.00)(1 + 1.8834)] calculation uses 2002 data to calculate the sustainable 2003 g.

22. 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.