Chapter 2 Analysis of Solvency, Liquidity, and Financial Flexibility

Order Placed Order Received < Inventory > Sale Accounts Collection < Receivable > < Float > Cash Received

Time ==> Accounts < Payable > Invoice Received Disbursement < Float > Payment Sent

Cash Paid

Learning Objectives
Differentiate between solvency, liquidity, and financial flexibility ratios y Recognize that liquidity, broadly defined, includes solvency, narrow liquidity, and financial flexibility y Conduct a solvency analysis y Conduct a liquidity analysis y Assess a firms financial flexibility position
y

Financial Statements - Basic Source of Information

y y y

Balance Sheet Income Statement Statement of Cash Flows

Solvency Measures
y y y y

Current Ratio Quick Ratio Net Working Capital Net Liquid Balance (really gets at liquidity, too) Working Capital Requirements

Current Ratio
Current assets Current ratio = ------------------------Current liabilities $6,339 Current ratio = ----------- = 1.72 $3,695 1995 1.96 1996 2.08 1997 1.66 1998 1.45 1999 1.72

Current ratio

Quick Ratio
Current assets - Inventories Quick ratio = ------------------------------------Current liabilities $6,339 - $273 Quick ratio = -------------------- = $3,695 1995 1.57 1996 1.63

1.64

Quick ratio

1997 1.51

1998 1.36

1999 1.64

Net Working Capital

Net working capital = CA - CL

Net working capital = $6,339 - $3,695 = $2,644

($ Millions) Net working capital

1995 1996 1997 1998 1999 $ 719 $1,018 $1,089 $1,215 $2,644

NWC and its Component Parts

CA Cash Mkt Sec A/R Inventory Prepaid A/P N/P CMLTD Accruals CL CA Cash Mkt Sec A/R Inventory Prepaid A/P N/P CMLTD Accruals CL CA Cash Mkt Sec A/R Inventory Prepaid A/P N/P CMLTD Accruals CL

NWC = CA - CL

WCR = A/R + INV +Pre - A/P - Accruals Working Capital Requirements

NLB = Cash + M/S - N/P - CMLTD + Net Liquid Balance

Net Working Capital =

Working Capital Requirements

($2,481+$273+$404) - ($2,397+$355+$943) WCR/S = ----------------------------------------------------------$18,243 ($537) = ----------- = -0.029 $18,243 1995 .055 1996 .082 1997 -.030 1998 -.039 1999 -.029

WCR/S

Net Liquid Balance

Net liquid balance = Cash + Equiv. - (N/P + CMLTD) Net liquid balance = $3,181 - $0 = $3,181

($ Millions) Net liquid balance

1995 $527

1996 1997 1998 1999 $586 $1,325 $1,698 $3,181

What is Liquidity?
y

Ingredients
Time Amount Cost

Definition
Having enough financial resources to cover financial obligations in a timely manner with minimal costs

What is Liquidity - Examples

y y y

Amount and trend of internal cash flow Aggregate available credit lines Attractiveness of firms commercial paper and other financial instruments Overall expertise of management

Liquidity Measures (Narrow Liquidity)

y

Cash Flow From Operations

from Statement of Cash Flows

y y y

Cash Conversion Period Current Liquidity Index Lambda (also financial flexibility measure; more on this later)

Cash Flow From Operations

Dells Cash Flow From Operations

($ Millions) CFFO

1995 $243.4

1996 1997 1998 1999 $175.0 $1,362.0 $1,592.0 $2,436.0

Cash Conversion Chart

Inventory stocked Days inventory held

Inventory sold Days sales outstanding

Cash received

Days payables outstanding

Cash conversion period Cash disbursed

Cash Conversion Period Calculations

Cash conversion period = DIH + DSO - DPO (Days) DIH DSO 1995 40 57 ------Operating cycle 97 DPO 60 ------Cash conversion period 37 1996 1997 1998 37 15 9 50 42 44 ----------- -----87 57 53 41 63 63 ------- ------- ------46 -6 -10 1999 7 50 -----57 62 -------5

How Much Liquidity is Enough?

y y y

Solvency - a stock or balance perspective Liquidity - a flow perspective Liquidity management involves finding the right balance of stocks and flows Lets look at a couple of measures that combine the two

Current Liquidity Index

Cash assets t-1 + CFFO t CLI = --------------------------------N/P t-1 + CMLTD t-1 $1,844 + $2,436 CLI = -------------------- = 29.32 $146 + $0 1996 1,755.62 1997 33.47 1998 85.00 1999 29.32

CLI

Lambda

Initial liquid Total anticipated net cash flow reserve + during the analysis horizon Lambda = ------------------------------------------------------------------Uncertainty about the net cash flow during the analysis horizon

Financial Flexibility (one measure in text; Fitch offers another measure)

Sustainable Growth Rate Concept: Uses New Assets gS(A/S) = Sources = New Equity + New Debt = m(S+gS)(1-d) + m(S+gS)(1-d)(D/E) m(S+gS)(1m(S+gS)(1m(1m(1-d)[1 + (D/E)] g* = ---------------------------------(A/S) - {m(1-d)[1 + (D/E)]} {m(1.0765 x (1 - .00) x (1 + 2.3008) g*= ------------------------------------------------- = 270.49% .3462 - [.0765 x (1 - .00)(1 + 2.3008)] calculation uses 1998 data to calculate the sustainable 1999 g*.

Summary
y

Chapter introduced basic concepts of:

solvency liquidity financial flexibility

y y y

Solvency: an accounting concept comparing assets to liabilities Liquidity: related to a firms ability to pay for its current obligations in a timely fashion with minimal costs Financial flexibility: related to a firms overall financial structure and if financial policies allow firm enough flexibility to take advantage of unforeseen opportunities.