1. L ESSON 6 – S UMMARY – L IQUIDITY AND S OLVENCY Analysis of the financial situation The concept of Liquidity and Solvency The traditional approach: the rule of the minimum solvency The concept of Working Capital and its role in the liquidity and solvency The modern financial equilibrium: the fundamental equation in Liquidity 01 FF - LE/LFC/LG/LGM - 2013/2014

2. B ALANCE S HEET A NALYSIS (1/2) The balance can be viewed as the representation of what the firm owns (assets) and how it is financed (equity and liabilities). The assets, however, do not have the same degree of liquidity (of conversion into cash) and the funds do not have to be paid back in the same time: On the assets side, for example, a trade receivable will become available in cash sooner than an inventory (because this must be sold first and only then it will become a trade receivable...); On the funds side, for example, the firm has to pay a trade payable before a 3 year loan. In a simplified perspective we can make a further breakdown of the assets and resources: turned into cash and required payment - within a year and more than a year. 02 FF - LE/LFC/LG/LGM - 2013/2014

3. B ALANCE S HEET A NALYSIS (2/2) So we will divide the assets in: Current assets (≤ 1 year) Non-current asset (> 1 year) And the resources in: Current liability (≤ 1 year) Non-current liabilities + equity (> 1 year) To have a balanced financial situation, a firm should naturally have investments and resources with similar degrees of liquidity and of being paid in time, respectively. 03 FF - LE/LFC/LG/LGM - 2013/2014

4. RULE OF MINIMUM FINANCIAL BALANCE AND THE NET PERMANENT CAPITAL (1/2) We have therefore, only considering the large subdivision until 1 year and more than 1 year, the first rule of balance, called the minimum financial equilibrium: Current Assets = Current Liabilities(1)or, equivalent: Non-current Assets = Non-current Liabilities + Equity (2) Usually, the resources to be paid in more than 1 year (non-current liabilities and equity) are named as PERMANENT FUNDS, in which the word "permanent" only indicates that these capitals will stay for a long period of time in the firm (note that the Liabilities will eventually be paid). So we can rewrite the equation (2): Non-current Assets = Permanent Funds (3) 04 FF - LE/LFC/LG/LGM - 2013/2014

5. RULE OF MINIMUM FINANCIAL BALANCE AND THE NET PERMANENT CAPITAL (2/2) This equation (3) allows us to present the concept of NET PERMANENT CAPITAL (NPC): Net Permanent Capital = Permanent Funds – Non-current Assets Thus, the rule of minimum balance is verified when: NPC = 0 If the NPC is positive, it means that there is an excess of permanent funds (i.e. to be balanced the firm would not need a so high value in permanent funds, that is, could have a lower value in long term and a higher value in current liabilities). If the NPC is negative, it means that there is a lack of permanent funds. 05 FF - LE/LFC/LG/LGM - 2013/2014

6. L IMITS TO THE B ALANCE AND THE CONCEPT OF W ORKING C APITAL (1/6) If we examine more closely some current assets and liabilities, we may realize that including all of them in short term (1 year) is elusive. Although they are short-term values, because they constantly renew, they have, after all, a long-term permanency on the firm. Let's look at two examples: Imagine a company that gives its customers a one month deadline for these to pay; There is no doubt that every sale that the company does will generate a short-term credit (trade receivables, current assets), but as the company is constantly selling, it will have a permanent trade receivable, i.e. permanently in the current assets will stay a credit on customers of approximately one month sales. Similar example, but now on the funds side, we could refer to the amount in trade payables (current liabilities). 06 FF - LE/LFC/LG/LGM - 2013/2014

7. L IMITS TO THE B ALANCE AND THE CONCEPT OF W ORKING C APITAL (2/6) Imagine a store that sells televisions and that for security reasons want to have always in stock 10 televisions (to not take the risk of not having TV sets to sell). So, at the same time the store is selling televisions, is also buying new to keep the inventory as wished; If it sells 10 televisions per month we can say that the store has a one month stock (inventory, current assets), but in reality it has permanently over time an inventory of 10 televisions. We have, therefore, a set of values of current assets and liabilities related to the operating activities of the firm that actually have a long-term permanency. 07 FF - LE/LFC/LG/LGM - 2013/2014

8. L IMITS TO THE B ALANCE AND THE CONCEPT OF W ORKING C APITAL (3/6) We call them OPERATING NEEDS and OPERATING RESOURCES. The most relevant are: Needs Trade Receivables Inventory Resources Trade Payables Government ( from having some time given to pay the VAT and amounts to Social Security) The difference between the operating Needs and Resources is called WORKING CAPITAL (WC): WC = Operating Needs – Operating Resources 08 FF - LE/LFC/LG/LGM - 2013/2014

9. L IMITS TO THE B ALANCE AND THE CONCEPT OF W ORKING C APITAL (4/6) It is important to detail the study of this concept of the Working Capital. If it is positive (which is the most common situation) represents a NET investment which must be funded on an ongoing basis. Let's take a closer look at a very simple example of this fact. EXAMPLE Consider a business that starts its activities and will sell 20,000 € per month; Assume that its only cost is the merchandise it sells and that there isn't any margin, i.e., sells at the price of purchase; Consider that the company works without inventories (purchases to sell), provides its customers with a credit of 3 months and gets from its suppliers a credit of 1 month; Ignore the existence of taxes (VAT in particular). Let us present a table showing the amounts of cash to be collected and paid monthly: 09 FF - LE/LFC/LG/LGM - 2013/2014

10. L IMITS TO THE B ALANCE AND THE CONCEPT OF W ORKING C APITAL (5/6) 10 FF - LE/LFC/LG/LGM - 2013/2014 Month 1Month 2Month 3Month 4 REVENUES COLLECTED---20,000* COST of GOODS PAID-20,000**20,000 Balance-(20,000) - Acumulated-(20,000)(40,000) * Sales from month 1 will be turned into cash on month 4; ** On month 2 it pays the amount relative to the cost of month 1. As can be seen the company will accumulate a deficit that touches the 40,000 in month 3 and stabilizes from there. However this value will stay over time, i.e., it is a permanent investment. Represents the value of the company's Working Capital, that is, a value that must be permanently invested so the firm can develop its activity.

11. L IMITS TO THE B ALANCE AND THE CONCEPT OF W ORKING C APITAL (6/6) Let's take a look at how we would reach the same value (40,000), using directly the concept of Working Capital. In this case the firm has only an operating need (trade receivables) and one operating resource (trade payables). After the first few months of activity let us look at the values that the company will permanently have in trade receivables and trade payables: Trade Receivables: 60,000 ( 3 months of sales) Trade Payables: 20,000 (1 month) Then, the WC will be equal to: WC = 60,000 -20,000 = 40,000 11 FF - LE/LFC/LG/LGM - 2013/2014

12. THE NEW CONCEPT OF FINANCIAL BALANCE USING THE WC (1/3) 12 FF - LE/LFC/LG/LGM - 2013/2014 Understood the concepts of operating needs and resources (and WC), resuming the equation (3) of the rule of minimum financial balance (Non-current Assets = Permanent Funds), we can rewrite it considering now and also these values of current but permanent assets and liabilities: Non-current Assets + Operating Needs = Permanent Funds + Operating Resources Moving the Operating Resources to the left side: Non-current Assets + Operating Needs – Operating Resources = Permanent Funds

13. THE NEW CONCEPT OF FINANCIAL BALANCE USING THE WC (2/3) 13 FF - LE/LFC/LG/LGM - 2013/2014 Using the concept of WC: Non-current Assets + WC = Permanent Funds Using the concept of Net Permanent Capital (Permanent Funds – Non- current Assets): WC = NPC And thus we have two presentations of the fundamental equation of financial equilibrium. If that equality does not arise, we will have a Positive Liquidity or a Negative one; using the first expression: L = Permanent Funds – (Non-current Assets + WC) In addition to the equality (desirable) where L = 0, there may be two distinct situations:

14. THE NEW CONCEPT OF FINANCIAL BALANCE USING THE WC (3/3) 14 FF - LE/LFC/LG/LGM - 2013/2014 Non-current Assets + WC > Permanent Funds In this case: L < 0. The permanent capital level is insufficient to cover the longest term assets. This does not necessarily mean that the company is in financial difficulties. It may have chosen, for example, to finance the assets with short-term loans. The problem is that the firm has to regularly renew such funding and with two risks: don't get the credit at all, anymore, or get it on more disadvantageous conditions. Non-current Assets + WC < Permanent Funds In this case: L > 0. The firm does not need to have a so large amount of permanent capital. It can choose better by more short-term financing (lower cost and greater flexibility).