Part III – Financial Analysis

6. Liquidity and Solvency Analysis

(Credit analysis)

88

Liquidity

 Liquidity - Ability to convert assets into

cash or to obtain cash to meet short-term
obligations
Lack of liquidity can limit: Severe illiquidity often precedes:
Advantages of discounts Lower profitability
Profitable opportunities Restricted opportunities
Management actions Loss of owner control
Coverage of current obligations Loss of capital investment
Insolvency and bankruptcy

99

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 Liquidity

 Current Assets - Cash and other assets reasonably

expected to be (1) realized in cash, or (2) sold or
consumed, during the longer of one-year or the operating
cycle
 Current Liabilities - Obligations to be satisfied within a
relatively short period, usually a year
 Current Ratio – Current Assets/Current Liabilities
– Relevant measure of current liability coverage, buffer
against losses and reserve of liquid funds
– Limitations – A static measure

Working Capital
O Indicador Fundo de Maneio (FM)
 Static definition
Investment point of view: the excess of current assets over
current liabilities
Working capital = Current assets – Current liabilities

Financing point of view: the excess of long-term financing

over non-current assets
Working capital = Long-term financing – Non-current assets
91

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 Working capital requirements
Necessidades de Fundo de Maneio (NFM)
ou FM necessário
 Dynamic definition:
Working capital requirements – amount of money tied up
in the operating cycle that has to be funded and can
significantly drain the resources required for investment in
assets
– Receivables + Inventories - Payables
– It is necessary to study the operating cycle of a
company to know its working capital
requirements/needs
 they depend on the type and volume of business 92

Operating cycle

 Operating cycle – lenght of time, usually measured in

days, between a company’s purchase of inventory (raw
materials or goods) and the receipt of cash from accounts
receivable
= Inventory Days + Receivable Days

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 Net Trade Cycle (Ciclo de Caixa)
or Cash Conversion Cycle
Payable Days Net trade cycle

Goods Payment to
purchase suppliers

Inventory Days Receivable Days

Goods Goods sale Collection

purchase from
customers
 The net trade cycle corresponds to the number of days during which a
company has to finance its operating activities using external financing
 This happens because the credit of suppliers is not sufficient to finance
the full length of the operating cycle 94

Net Trade Cycle (Ciclo de Caixa)

or Cash Conversion Cycle
 Example 1
Inventory Days = 78
Receivable Days = 60
Payable Days = 15

 Net trade cycle = 78 + 60 - 15 = 123

95

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 Net Trade Cycle (Ciclo de Caixa)
or Cash Conversion Cycle
 Example 2
Inventory Days = 15
Receivable Days = 0
Payable Days = 45
Net trade cycle = ?
Conclusion about Working capital requirements:
________________________________________________
________________________________________________

96

How to compute Working capital

requirements?

I) Indirect method (Using net trade cycle)

1) Compute the operating activity ratios in days of sales
 Collection period or Receivable Days = Accounts
Receivable/Sales*365
 Days’ sales in Inventories or Inventory Days =
Inventories/Sales*365
 Days’ sales in accounts payable = Accounts
Payable/Sales*365
97

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 How to compute Working capital
requirements?

I) Indirect method (Using net trade cycle)

2) Obtain the net trade cycle in days of sales
Collection period or Receivable Days
+
Days’ sales in Inventories
-
Days’ sales in Accounts Payable

98

How to compute Working capital

requirements?

I) Indirect method (Using net trade cycle)

3) Compute Working capital requirements
Working capital requirements =
Net trade cycle in days of sales*Sales/365

99

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 How to compute Working capital
requirements?

II) Direct method

– This method consists in obtaining working capital requirements
from the Functional Balance Sheet (Balanço Funcional)
The Functional Balance sheet is an adjusted balance sheet
that presents the assets and sources of financing according to
the different financial cycles of the company
The financial cycles are the financial result of the decisions
made at different levels: strategic decisions, operating
decisions and financial decisions,...

100

Functional Balance Sheet

The financial cycles

 Three type of financial cycles:

– Investment cycle (Ciclo de Investimento)
– Operating cycle (Ciclo de Exploração)
– Financing cycle (Ciclo de Operações Financeiras)
 Long-term financing (Ciclo de Operações de Capital)
 Short-term financing (Ciclo de Operações de Tesouraria)

101

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 Functional Balance Sheet
The Financial cycles

 The functional balance sheet obtained is:

CYCLE INVESTMENTS FINANCING CYCLE

Non-Current Assets Shareholders’ Equity LONG-TERM FINANCING

INVESTMENT
Long-term financing

OPERATING Operating current Operating current OPERATING

assets liabilities
SHORT-TERM Cash & Equivalents Short-term financing SHORT-TERM
FINANCING FINANCING
and other current and other current
assets liabilities
102

Functional Balance Sheet

N N+1
1) Shareholders' Equity
2) Long-term or stable liabilities
3) Long-term or stable financing (1+2)
4) Non-current Assets
5) Working Capital (3-4)
6) Inventories
7) Accounts Receivable
8) Other operating receivables
…
9) Operating current assets (6+7+8+…)
10) Accounts Payable
11) Other operating payables
…
12) Operating current liabilities (10+11+…)
13) Working capital requirements (9 -12)
103
14) NET LIQUIDITY (5-13)

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 Functional Balance Sheet

 Net Liquidity = Financial resources – Financing Needs

 Working Capital = Long-term financing – Non-current assets
 Working capital requirements = Operating current assets-operating
current liabilities
 Then
Net Liquidity = Working Capital – Working Capital Requirements

The Fundamental Treasury Relation

if >0, there is a positive net liquidity
104
if <0, there is a negative net liquidity

Net Liquidity

(+) Working Capital (-)

(-) Working capital (+)

(a) NL < 0
(b) NL < 0
requirements

(c) NL > 0

(e) NL > 0
(d) NL > 0
(f) NL< 0

Source: Adapted from Moreira, 1997, p.150 105

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 Functional Balance Sheet
Limitations

 Critics to the functional balance sheet:

– It is difficult to reclassify all the items/accounts in the balance
sheet according to the respective financial cycle
– It is difficult to identify stable financing sources: some short-term
loans may be stable due to the fact that they can be regularly
renewed (ex. some bank overdrafts)

106

Liquidity ratios

 Ratios that compare current assets with current liabilities:

– Current ratio (Rácio Liquidez Geral)
– Quick ratio (Rácio Liquidez Reduzida)
– Cash-to-current liabilities ratio (Rácio Liquidez Imediata)
 Operating activity ratios:
– Collection period ratio (Accounts Receivable Turnover)
– Days to sell Inventory ratio (Inventory Turnover)
– Days Accounts Payable Outstanding (Accounts payable
Turnover)
107

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 Operating Activity Analysis of Liquidity

Accounts Receivable Liquidity Measures

 Accounts Receivable Turnover

 Days’ Sales in Receivables

 Receivables collection period

Operating Activity Analysis of Liquidity

Interpretation of Receivables Liquidity Measures

 Accounts receivable turnover rates and collection periods

are usefully compared with industry averages or with
credit terms
 Ratio Calculation: Gross or Net?
 Trend Analysis
– Collection period over time
– Observing the relation between the provision for doubtful
accounts and gross accounts receivable

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 Operating Activity Analysis of Liquidity

Inventory Turnover Measures

 Inventory turnover ratio:

– Measures the average rate of speed at which inventories move

through and out of a company.
Illustration (Day’s sales in inventory)
 Days to sell Inventory:

– Shows the number of days required to sell ending inventory

Operating Activity Analysis of Liquidity

Days’ Purchases in Accounts Payable

 Days’ Purchases in Accounts Payable

– Measures the extent accounts payable represent current and
not overdue obligations

 Accounts Payable Turnover

– Indicates the speed at which a company pays for purchases on
account.

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 Additional Liquidity Measures

 Cash Flow Measures

– Cash Flow Ratio

– Overcomes the static nature of the current ratio since its numerator
reflects a flow variable.
 Financial flexibility - Ability to take steps to counter
unexpected interruptions in the flow of funds
– Ability to borrow from various sources; to raise equity capital;
to sell and redeploy assets; to adjust the level and direction of
operations to meet changing circumstances; levels of
prearranged financing and open lines of credit

Solvency Analysis

 Solvency - long-run financial viability and its ability to cover

long-term obligations

– Capital structure - financing sources and their

attributes

– Earning power - recurring ability to generate cash from

operations

113

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 Solvency Analysis

 Two necessary conditions:

1st) The structure of capital should lay on Shareholders’ Equity
2nd) To a sustainable solvency a company should generate
operating profits

Solvency = f(Level of Shareholders’ Equity; Operating profitability)

114

Capital Structure Analysis

 Shareholders’ Equity vs Debt

– Equity financing
Risk capital of a company
Uncertain and unspecified return
Lack of any repayment pattern
Contributes to a company’s stability and solvency

– Debt financing
Must be repaid with interest
Specified repayment pattern
115

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 Capital Structure Analysis

 Motivation for Debt:

– From a shareholder’s perspective, debt is a preferred
external financing source:
Interest on most debt is fixed
Interest is a tax-deductible expense
– Financial leverage - the amount of debt financing in a
company’s capital structure

116

Solvency Ratios

Capital structure ratios

– Total debt to total assets or Financial Leverage
(Endividamento)= Total Liabilities/Total Assets
– Debt to Equity Ratio = Total Liabilities/Shareholders’ Equity
– Shareholders’ equity to total liabilities (Solvabilidade
Geral) = Shareholders’ Equity/Total Liabilities
– Shareholders’ equity to non-current liabilities
(Solvabilidade Reduzida)= Shareholders’ Equity/Non current
Liabilities
117

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 Solvency Ratios

Capital structure ratios

– Shareholders’ equity to total assets ratio (Autonomia
Financeira) = Shareholders’ Equity/Total Assets
– Non-current liabilities to non-current assets ratio
(Cobertura do Imobilizado) = Long-term financing/Non-
current assets
 Earnings coverage ratios
– Interest coverage ratio (Cobertura dos Encargos
Financeiros) = EBIT/Interest Expense
– ... 118

Loss and Recovering of Solvency

 When does a company become insolvent?

– When a company cannot meet its current liabilities (as they
come due), when it does not have liquidity and its financial
structure does not allow its recovering
 How is insolvency detected?
– A gradual and systematic detioration of the solvency ratios
reflecting a situation in which a company is increasingly
dependent on its creditors

119

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 Loss and Recovering of Solvency

 Two distinct situations:

– Insolvency (and technical insolvency): usually a temporary
condition
– Bankruptcy: legal declaration of bankruptcy and
consequent liquidation of company’s assets

120

Loss and Recovering of Solvency

 An insolvent company may be recovered if it is possible to

restore its financial equilibrium in the future
 How to know if a company is recoverable?
– Will the company generate operating profits in the
future?
– It will be necessary to prepare projected financial
statements and to compute the financing needs to pay
debts and interest expenses
121

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 Loss and Recovering of Solvency

 Financial Restructuring Measures (medidas de saneamento

financeiro ou de consolidação financeira e reestruturação
empresarial)
– Consolidation of liabilities (Consolidação do Passivo):
creditors’ agreement to extend payment deadlines (short-
term debts become long-term debts);
– Transformation of debt into equity (Transformação das
dívidas em capital): creditors’ agreement in which some
creditors become shareholders;
122

Loss and Recovering of Solvency

– Debt relief (Perdão das dívidas) (usually below to 50%);

– Entry of new capital (Saneamento com entrada de novos
capitais):
Long-term bank loan (sooner the long-term loan becomes a
short-term liability)
Capital increase (new shares issue)

123

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 Loss and Recovering of Solvency

 Portuguese legislation:
– D.L. 132/93
– D.L. 315/98
– D.L. 53/2004 de 18 de Março (CIRE - Código de Insolvência e
Recuperação de Empresas)
 Lei nº 16/2012 de 20 Abril established processo especial de
revitalização
http://www.guiadasinsolvencias.pt/legislaccedilatildeo.html

124

 Bibliography:
– Neves, J. C. (2012). Análise e Relato Financeiro – um visão
integrada de gestão, Texto Editores (Parte III – Solidez financeira
e equilíbrio financeiro, cap. 9, 10 e 11)
– Subramanyam (2014). Financial Statement Analysis, McGraw-
Hill International Edition (cap. 10)

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