Chapter 2

Analysis of Solvency, Liquidity, and

Financial Flexibility

Order Order Sale Payment Sent Cash

Placed Received Received
Accounts Collection
< Inventory > < Receivable > < Float >

Time ==>
Accounts Disbursement
< Payable > < Float >

Invoice Received Payment Sent Cash

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by Thomson Learning, Inc.
Learning Objectives

Differentiate between solvency and liquidity ratios

Conduct a liquidity analysis
Assess a firms financial flexibility position

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Financial Statements - Basic Source
of Information

Balance Sheet

Income Statement

Statement of Cash Flows

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Solvency Measures

Current Ratio

Quick Ratio

Net Working Capital

Net Liquid Balance

Working Capital Requirements

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 Current Ratio

Current assets
Current ratio = -------------------------
Current liabilities

$8,924
Current ratio = ------------ = 1.00
$8,933

1999 2000 2001 2002 2003

Current ratio 1.72 1.48 1.45 1.05 1.00

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 Quick Ratio

Current assets - Inventories

Quick ratio = -------------------------------------
Current liabilities

$8,924 - $306
Quick ratio = ------------------- = .96
$8,933

1999 2000 2001 2002 2003

Quick ratio 1.64 1.40 1.39 1.01 0.96

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 Net Working Capital

Net working capital = CA - CL

Net working capital = $8,924 - $8,933

= ($9)

($000,000) 1999 2000 2001 2002 2003

Net working capital $2,644 $2,489 $2,948 $358 ($9)

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 NWC and its Component Parts

CA CL CA CL CA CL

Cash Cash Cash

Mkt Sec Mkt Sec Mkt Sec

A/R A/P A/R A/P A/R A/P

Inventory N/P Inventory N/P Inventory N/P

Prepaid CMLTD Prepaid CMLTD Prepaid CMLTD

NWC = CA - CL WCR = A/R + INV +Pre NLB = Cash + M/S

- A/P - N/P - CMLTD

Net Working Capital Working Capital Requirements

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Net Liquid Balance
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 Working Capital Requirements

($2,586+$306+$1,394) - ($5,989+$54+$1,458+$1,432)
WCR/S = -------------------------------------------------------------------
$35,404

($4,647)
= ---------- = -.1313
$35,404

1999 2000 2001 2002 2003

WCR/S - 0.029 -0.065 -0.078 -0.114 -0.131
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 Net Liquid Balance

Net liquid balance = Cash + Equiv. - (N/P + CMLTD)

Net liquid balance = $4,638 - ($0)

= $4,638

($000,000) 1999 2000 2001 2002 2003

Net liquid balance $3,181 $4,132 $5,438 $3,914 $4,638

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What is Liquidity?

Ingredients
Time
Amount
Cost
Definition
Having enough financial resources to cover financial obligations
in a timely manner with minimal costs

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What is Liquidity - Examples

Amount and trend of internal cash flow

Aggregate available credit lines

Attractiveness of firms commercial paper and

other financial instruments

Overall expertise of management

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Liquidity Measures

Cash Flow From Operations

Cash Conversion Efficiency

Cash Conversion Period

Current Liquidity Index

Lambda

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 Cash Flow From Operations

($ 000,000) 1999 2000 2001 2002 2003

CFFO $2,436 $3,926 $4,195 $3,797 $3,538

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 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

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 Cash Conversion Chart

Inventory Inventory Cash

stocked sold received

Days inventory held Days sales outstanding

Days payables outstanding Cash conversion

period

Cash
disbursed

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 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

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How Much Liquidity is Enough?

Solvency - a stock or balance perspective

Liquidity - a flow perspective

Liquidity management involves finding the right

balance of stocks and flows

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 Current Liquidity Index

Cash assets t-1 + CFFO t

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

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 Lambda

Initial liquid Total anticipated net cash flow

reserve + during the analysis horizon
Lambda = -------------------------------------------------------------------
Uncertainty about the net cash flow during the
analysis horizon

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 Financial Flexibility
Sustainable Growth Rate Concept:

Uses = Sources
New Assets = New Equity + New Debt
gS(A/S) = m(S+gS)(1-d) + m(S+gS)(1-d)(D/E)

m(1-d)[1 + (D/E)]
g = ----------------------------------
(A/S) - {m(1-d)[1 + (D/E)]}

.039977 x (1 - 0.00) x (1 + 1.8834)

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

Chapter introduced basic concepts of:

solvency
liquidity
financial flexibility
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 allows
firm enough flexibility to take advantage of
unforeseen opportunities.
Copyright 2005 by Thomson Learning, Inc.