Chapter 2 Analysis of Solvency, Liquidity, and Financial Flexibility

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

2. Learning Objectives • To develop an understanding of liquidity • 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 • $15,338 • Current ratio = ------------ = 1.54 • $9,973 • 1991 1992 1993 1994 1995 • Current ratio 1.61 1.71 1.51 1.64 1.54

6. Quick Ratio • Current assets - Inventories • Quick ratio = ------------------------------------- • Current liabilities • $15,338 - $14,064 • Quick ratio = ------------------------ = .13 • $9,973 • 1991 1992 1993 1994 1995 • Quick ratio .15 .24 .14 .15 .13

7. Net Working Capital Net working capital = CA - CL Net working capital = $15,338 - $9,973 = $5,365 ($000,000) 1991 1992 1993 1994 1995 Net working capital $2,425 $3,571 $3,444 $4,709 $5,365 Grant’s NWC averaged about $371 million

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

9. Working Capital Requirements • ($900+$14,064+$329) - ($5,907+$365+$1,819) • WCR/S = ----------------------------------------------------------- • $82,494 • $7,202 • = ----------- = .09 • $82,494 • 1991 1992 1993 1994 1995 • WCR/S .09 .09 .09 .10 .09 • Grant’s WCR/S ratio averaged .42

10. Net Liquid Balance • Net liquid balance = Cash + Equiv. - (N/P + CMLTD) • Net liquid balance = $45 - ($1,795 + $87) • = ($1,837) • ($000,000) 1991 1992 1993 1994 1995 • Net liquid balance ($413) ($463) ($1,636) ($1,626) ($1,837) • Grant’s NLB ran at a deficit

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 (Ludeman) • 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 (narrow) • Cash Conversion Period(narrow) • Current Liquidity Index(narrow) • Lambda(broad)

14. Cash Flow From Operations ($ Billions) 1991 1992 1993 1994 1995 CFFO or OCF $1.29 $1.37 $1.27 $2.19 $2.91 W.T. Grant’s CFFO was a deficit for 8 of its last 10 years. Wal - Mart’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 (Wal-Mart) Cash conversion period = DIH + DSO - DPO (Days) 1991 1992 1993 1994 1995 DIH 84.02 78.55 77.68 76.40 79.57 DSO 6.10 9.15 5.51 4.87 3.98 ------- ------ ------ ------ ------ Operating cycle 90.12 87.70 83.19 81.27 83.55 DPO 38.46 36.74 32.46 28.47 33.42 ------- ------- ------- ------- ------- Cash conversion period 51.66 50.96 50.73 52.80 50.13 Grant’s cash conversion period exceeded 200 days!

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 • $20 + $2,906 • CLI = ------------------ = 1.78 • $1,575 + $71 • 1992 1993 1994 1995 • CLI 3.21 2.65 1.34 1.78 • W.T. Grant’s current liquidity index ran at a deficit.

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)]} • .0346 x (1 - .1282) x (1 + 1.4590) • g = ------------------------------------------------- = 23.30% • .3926 - [.0346 x (1 - .1282)(1 + 1.4590)] • calculation uses 1994 data to calculate the sustainable 1995 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 allows firm enough flexibility to take advantage of unforeseen opportunities.