Chapter 2
Analysis of Solvency, Liquidity,
and Financial Flexibility
Order Order Sale Cash
Placed Received Received
Accounts Collection
Time ==>
Accounts Disbursement
Invoice Payment Cash
Received Sent Paid
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Learning Objectives
Differentiate between solvency, liquidity, and
financial flexibility ratios
Recognize that liquidity, broadly defined, includes
solvency, narrow liquidity, and financial flexibility
Conduct a solvency analysis
Conduct a liquidity analysis
Assess a firm’s 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
(really gets at liquidity, too)
Working Capital Requirements
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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
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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
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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
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NWC and its Component Parts
CA CL CA CL CA CL
Cash Cash Cash
Mkt Sec A/P Mkt Sec A/P Mkt Sec A/P
A/R N/P A/R N/P A/R N/P
Inventory CMLTD Inventory CMLTD Inventory CMLTD
Prepaid Accruals Prepaid Accruals Prepaid Accruals
NWC = CA - CL WCR = A/R + INV +Pre NLB = Cash + M/S
- A/P - Accruals - N/P - CMLTD
Net Working Capital = Working Capital Requirements + Net Liquid Balance
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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
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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 $3,181
Copyright 2002 by South-Western, a division of Thomson Learning TM
What is Liquidity?
Ingredients
– Time
– Amount
– Cost
Definition
– “ Having enough financial resources to cover financial
obligations in a timely manner with minimal costs”
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What is Liquidity - Examples
Amount and trend of internal cash flow
Aggregate available credit lines
Attractiveness of firm’s commercial paper and
other financial instruments
Overall expertise of management
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Liquidity Measures (Narrow
Liquidity)
Cash Flow From Operations
– from Statement of Cash Flows
Cash Conversion Period
Current Liquidity Index
Lambda (also financial flexibility measure; more
on this later)
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Cash Flow From Operations
Dell’s Cash Flow From Operations
($ Millions) 1995 1996 1997 1998 1999
CFFO $243.4 $175.0 $1,362.0 $1,592.0 $2,436.0
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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) 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
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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
Let’s look at a couple of measures that combine the
two
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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
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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 (one measure in
text; Fitch offers another measure)
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*.
Copyright 2002 by South-Western, a division of Thomson Learning TM
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.
Copyright 2002 by South-Western, a division of Thomson Learning TM