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Chapter 2 Analysis of Solvency, Liquidity, and Financial Flexibility

Chapter 2 Analysis of Solvency, Liquidity, and Financial Flexibility. Order Order Sale Cash Placed Received Received Accounts Collection

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Chapter 2 Analysis of Solvency, Liquidity, and Financial Flexibility

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  1. Chapter 2Analysis of Solvency, Liquidity, and Financial Flexibility • Order Order Sale Cash • Placed Received Received • Accounts Collection • < Inventory > < Receivable > < Float > • Accounts Disbursement Time ==> • < Payable > < Float > • Invoice Payment Cash • Received Sent Paid

  2. Learning Objectives • Differentiate between solvency and liquidity ratios • Conduct a liquidity analysis • Assess a firm’s financial flexibility position

  3. Financial Statements - Basic Source of Information • Balance Sheet • Income Statement • Statement of Cash Flows

  4. Solvency Measures • Current Ratio • Quick Ratio • Net Working Capital • Net Liquid Balance • Working Capital Requirements

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

  6. Quick Ratio • Current assets - Inventories • Quick ratio = ------------------------------------- • Current liabilities • $6,339 - $273 • Quick ratio = -------------------- = 1.64 • $3,695 • 1995 1996 1997 1998 1999 • Quick ratio 1.57 1.63 1.51 1.36 1.64

  7. Net Working Capital Net working capital = CA - CL Net working capital = $6,339 - $3,695 = $2,644 ($ Millions) 1995 1996 1997 1998 1999 Net working capital $ 719 $1,018 $1,089 $1,215 $2,644

  8. NWC and its Component Parts CA CL CA CL CA CL Cash Cash Cash A/P Mkt Sec A/P A/P Mkt Sec Mkt Sec A/R A/R N/P A/R N/P N/P Inventory Inventory Inventory CMLTD CMLTD CMLTD Prepaid Prepaid Prepaid Accruals Accruals Accruals NWC = CA - CL WCR = A/R + INV +Pre NLB = Cash + M/S - Accruals - A/P - N/P - CMLTD Net Working Capital Working Capital Requirements Net Liquid Balance

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

  10. Net Liquid Balance • Net liquid balance = Cash + Equiv. - (N/P + CMLTD) • Net liquid balance = $3,181 - $0 • = $3,181 • ($ Millions) 1995 1996 1997 1998 1999 • Net liquid balance $527 $586 $1,325 $1,698 $3,181

  11. What is Liquidity? • Ingredients • Time • Amount • Cost • Definition • Having enough financial resources to cover financial obligations in a timely manner with minimal costs

  12. What is Liquidity - Examples • Amount and trend of internal cash flow • Aggregate available credit lines • Attractiveness of firm’s commercial paper and other financial instruments • Overall expertise of management

  13. Liquidity Measures • Cash Flow From Operations • Cash Conversion Period • Current Liquidity Index • Lambda

  14. Cash Flow From Operations ($ Millions) 1995 1996 1997 1998 1999 CFFO $243.4 $175.0 $1,362.0 $1,592.0 $2,436.0 Dell’s Cash Flow From Operations

  15. Cash Conversion Chart Inventory Inventory Cash stocked sold received Days inventory held Days sales outstanding Days payables outstanding Cash conversion period Cash disbursed

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

  17. 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

  18. 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 1997 1998 1999 • CLI 1,755.62 33.47 85.00 29.32

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

  20. 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)]} • .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.

  21. Summary • Chapter introduced basic concepts of: • solvency • liquidity • financial flexibility • Solvency: an accounting concept comparing assets to liabilities • Liquidity: related to a firm’s ability to pay for its current obligations in a timely fashion with minimal costs • Financial flexibility: related to a firm’s overall financial structure and if financial policies allow firm enough flexibility to take advantage of unforeseen opportunities.

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