Chapter 7: Liquidity Analysis and Financial Flexibility

Chapter 2Analysis of Solvency, Liquidity,and Financial FlexibilityChapter 2Analysis of Solvency, Liquidity,and Financial Flexibility

Order Order Sale CashOrder Order Sale Cash

Placed Received ReceivedPlaced Received Received

Accounts Collection Accounts Collection

< Inventory > < Receivable > < Float > < Inventory > < Receivable > < Float >

Time ==> Time ==>

Accounts Disbursement Accounts Disbursement

< Payable > < Float > < Payable > < Float >

Invoice Payment Cash Invoice Payment Cash

Received Sent Paid Received Sent Paid

Order Order Sale CashOrder Order Sale Cash

Placed Received ReceivedPlaced Received Received

Accounts Collection Accounts Collection

< Inventory > < Receivable > < Float > < Inventory > < Receivable > < Float >

Time ==> Time ==>

Accounts Disbursement Accounts Disbursement

< Payable > < Float > < Payable > < Float >

Invoice Payment Cash Invoice Payment Cash

Received Sent Paid Received Sent Paid

Learning ObjectivesLearning Objectives

vTo develop an understanding of liquidityvTo develop an understanding of liquidity

vDifferentiate between solvency and liquidity ratiosvDifferentiate between solvency and liquidity ratios

vConduct a liquidity analysisvConduct a liquidity analysis

vAssess a firm’s financial flexibility positionvAssess a firm’s financial flexibility position

Financial Statements -Basic Source ofInformationFinancial Statements -Basic Source ofInformation

vBalance SheetvBalance Sheet

vIncome StatementvIncome Statement

vStatement of Cash FlowsvStatement of Cash Flows

Solvency MeasuresSolvency Measures

vCurrent RatiovCurrent Ratio

vQuick RatiovQuick Ratio

vNet Working CapitalvNet Working Capital

vNet Liquid BalancevNet Liquid Balance

vWorking Capital RequirementsvWorking Capital Requirements

Current RatioCurrent Ratio

Current assets Current assets

Current ratio = -------------------------Current ratio = -------------------------

Current liabilities Current liabilities

$15,338 $15,338

Current ratio = ------------ = 1.54Current ratio = ------------ = 1.54

$9,973 $9,973

1991 1992 1993 1994 1995 1991 1992 1993 1994 1995

Current ratio 1.61 1.71 1.51 1.64 1.54Current ratio 1.61 1.71 1.51 1.64 1.54

Current assets Current assets

Current ratio = -------------------------Current ratio = -------------------------

Current liabilities Current liabilities

$15,338 $15,338

Current ratio = ------------ = 1.54Current ratio = ------------ = 1.54

$9,973 $9,973

1991 1992 1993 1994 1995 1991 1992 1993 1994 1995

Current ratio 1.61 1.71 1.51 1.64 1.54Current ratio 1.61 1.71 1.51 1.64 1.54

Quick RatioQuick Ratio

Current assets - Inventories Current assets - Inventories

Quick ratio = -------------------------------------Quick ratio = -------------------------------------

Current liabilities Current liabilities

$15,338 - $14,064 $15,338 - $14,064

Quick ratio = ------------------------ = .13Quick ratio = ------------------------ = .13

$9,973 $9,973

1991 1992 1993 1994 1995 1991 1992 1993 1994 1995

Quick ratio .15 .24 .14 .15 .13Quick ratio .15 .24 .14 .15 .13

Current assets - Inventories Current assets - Inventories

Quick ratio = -------------------------------------Quick ratio = -------------------------------------

Current liabilities Current liabilities

$15,338 - $14,064 $15,338 - $14,064

Quick ratio = ------------------------ = .13Quick ratio = ------------------------ = .13

$9,973 $9,973

1991 1992 1993 1994 1995 1991 1992 1993 1994 1995

Quick ratio .15 .24 .14 .15 .13Quick ratio .15 .24 .14 .15 .13

Net Working CapitalNet Working Capital

Net working capital = CA - CLNet working capital = CA - CL

Net working capital = $15,338 - $9,973Net working capital = $15,338 - $9,973

= $5,365 = $5,365

($000,000) 1991 1992 1993 1994 1995($000,000) 1991 1992 1993 1994 1995

Net working capital $2,425 $3,571 $3,444 $4,709 $5,365Net working capital $2,425 $3,571 $3,444 $4,709 $5,365

Grant’s NWC averaged about $371 million Grant’s NWC averaged about $371 million

Net working capital = CA - CLNet working capital = CA - CL

Net working capital = $15,338 - $9,973Net working capital = $15,338 - $9,973

= $5,365 = $5,365

($000,000) 1991 1992 1993 1994 1995($000,000) 1991 1992 1993 1994 1995

Net working capital $2,425 $3,571 $3,444 $4,709 $5,365Net working capital $2,425 $3,571 $3,444 $4,709 $5,365

Grant’s NWC averaged about $371 million Grant’s NWC averaged about $371 million

NWC and its ComponentPartsNWC and its ComponentParts

CashCash

Mkt SecMkt Sec

A/RA/R

InventoryInventory

PrepaidPrepaid

A/PA/P

N/PN/P

CMLTDCMLTD

CashCash

Mkt SecMkt Sec

A/RA/R

InventoryInventory

PrepaidPrepaid

A/PA/P

N/PN/P

CMLTDCMLTD

CashCash

Mkt SecMkt Sec

A/RA/R

InventoryInventory

PrepaidPrepaid

A/PA/P

N/PN/P

CMLTDCMLTD

CA CL CA CL CA CL CA CL CA CL CA CL

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

- A/P - N/P - CMLTD- A/P - N/P - CMLTD

Net Working Capital Net Working Capital

Working Capital Requirements Net Liquid BalanceWorking Capital Requirements Net Liquid Balance

Working CapitalRequirementsWorking CapitalRequirements

($900+$14,064+$329) - ($5,907+$365+$1,819) ($900+$14,064+$329) - ($5,907+$365+$1,819)

WCR/S = -----------------------------------------------------------WCR/S = -----------------------------------------------------------

$82,494 $82,494

$7,202$7,202

= ----------- = .09 = ----------- = .09

$82,494 $82,494

1991 1992 1993 1994 1995 1991 1992 1993 1994 1995

WCR/S .09 .09 .09 .10 .09WCR/S .09 .09 .09 .10 .09

Grant’s WCR/S ratio averaged .42 Grant’s WCR/S ratio averaged .42

($900+$14,064+$329) - ($5,907+$365+$1,819) ($900+$14,064+$329) - ($5,907+$365+$1,819)

WCR/S = -----------------------------------------------------------WCR/S = -----------------------------------------------------------

$82,494 $82,494

$7,202$7,202

= ----------- = .09 = ----------- = .09

$82,494 $82,494

1991 1992 1993 1994 1995 1991 1992 1993 1994 1995

WCR/S .09 .09 .09 .10 .09WCR/S .09 .09 .09 .10 .09

Grant’s WCR/S ratio averaged .42 Grant’s WCR/S ratio averaged .42

Net Liquid BalanceNet Liquid Balance

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

Net liquid balance = $45 - ($1,795 + $87)Net liquid balance = $45 - ($1,795 + $87)

= ($1,837) = ($1,837)

($000,000) 1991 1992 1993 1994 1995($000,000) 1991 1992 1993 1994 1995

Net liquid balance ($413) ($463) ($1,636) ($1,626) ($1,837)Net liquid balance ($413) ($463) ($1,636) ($1,626) ($1,837)

Grant’s NLB ran at a deficit Grant’s NLB ran at a deficit

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

Net liquid balance = $45 - ($1,795 + $87)Net liquid balance = $45 - ($1,795 + $87)

= ($1,837) = ($1,837)

($000,000) 1991 1992 1993 1994 1995($000,000) 1991 1992 1993 1994 1995

Net liquid balance ($413) ($463) ($1,636) ($1,626) ($1,837)Net liquid balance ($413) ($463) ($1,636) ($1,626) ($1,837)

Grant’s NLB ran at a deficit Grant’s NLB ran at a deficit

What is Liquidity?What is Liquidity?

vIngredientsvIngredients

–Time–Time

–Amount–Amount

–Cost–Cost

vDefinitionvDefinition

–Having enough financial resources to cover financialobligations in a timely manner with minimal costs–Having enough financial resources to cover financialobligations in a timely manner with minimal costs

What is Liquidity -Examples (Ludeman)What is Liquidity -Examples (Ludeman)

vAmount and trend of internal cash flowvAmount and trend of internal cash flow

vAggregate available credit linesvAggregate available credit lines

vAttractiveness of firm’s commercial paper andother financial instrumentsvAttractiveness of firm’s commercial paper andother financial instruments

vOverall expertise of managementvOverall expertise of management

Liquidity MeasuresLiquidity Measures

vCash Flow From Operations (narrow)vCash Flow From Operations (narrow)

vCash Conversion Period(narrow)vCash Conversion Period(narrow)

vCurrent Liquidity Index(narrow)vCurrent Liquidity Index(narrow)

vLambda(broad)vLambda(broad)

Cash Flow FromOperationsCash Flow FromOperations

($ Billions) 1991 1992 1993 1994 1995($ Billions) 1991 1992 1993 1994 1995

CFFO or OCF $1.29 $1.37 $1.27 $2.19 $2.91CFFO 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.W.T. Grant’s CFFO was a deficit for 8 of its last 10 years.

($ Billions) 1991 1992 1993 1994 1995($ Billions) 1991 1992 1993 1994 1995

CFFO or OCF $1.29 $1.37 $1.27 $2.19 $2.91CFFO 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.W.T. Grant’s CFFO was a deficit for 8 of its last 10 years.

Wal - Mart’s Cash Flow From OperationsWal - Mart’s Cash Flow From Operations

Cash Conversion ChartCash Conversion Chart

Inventory Inventory CashInventory Inventory Cash

stocked sold receivedstocked sold received

Days inventory held Days sales outstanding Days inventory held Days sales outstanding

Days payables outstanding Cash conversion Days payables outstanding Cash conversion

period period

Cash Cash

disbursed disbursed

Cash Conversion PeriodCalculations (Wal-Mart)Cash Conversion PeriodCalculations (Wal-Mart)

Cash conversion period = DIH + DSO - DPOCash conversion period = DIH + DSO - DPO

(Days) 1991 1992 1993 1994 1995(Days) 1991 1992 1993 1994 1995

DIH 84.02 78.55 77.68 76.40 79.57DIH 84.02 78.55 77.68 76.40 79.57

DSO 6.10 9.15 5.51 4.87 3.98DSO 6.10 9.15 5.51 4.87 3.98

------- ------ ------ ------ ------ ------- ------ ------ ------ ------

Operating cycle 90.12 87.70 83.19 81.27 83.55Operating cycle 90.12 87.70 83.19 81.27 83.55

DPO 38.46 36.74 32.46 28.47 33.42DPO 38.46 36.74 32.46 28.47 33.42

------- ------- ------- ------- ------- ------- ------- ------- ------- -------

Cash conversion period 51.66 50.96 50.73 52.80 50.13Cash conversion period 51.66 50.96 50.73 52.80 50.13

Grant’s cash conversion period exceeded 200 days!Grant’s cash conversion period exceeded 200 days!

Cash conversion period = DIH + DSO - DPOCash conversion period = DIH + DSO - DPO

(Days) 1991 1992 1993 1994 1995(Days) 1991 1992 1993 1994 1995

DIH 84.02 78.55 77.68 76.40 79.57DIH 84.02 78.55 77.68 76.40 79.57

DSO 6.10 9.15 5.51 4.87 3.98DSO 6.10 9.15 5.51 4.87 3.98

------- ------ ------ ------ ------ ------- ------ ------ ------ ------

Operating cycle 90.12 87.70 83.19 81.27 83.55Operating cycle 90.12 87.70 83.19 81.27 83.55

DPO 38.46 36.74 32.46 28.47 33.42DPO 38.46 36.74 32.46 28.47 33.42

------- ------- ------- ------- ------- ------- ------- ------- ------- -------

Cash conversion period 51.66 50.96 50.73 52.80 50.13Cash conversion period 51.66 50.96 50.73 52.80 50.13

Grant’s cash conversion period exceeded 200 days!Grant’s cash conversion period exceeded 200 days!

How Much Liquidity isEnough?How Much Liquidity isEnough?

vSolvency - a stock or balance perspectivevSolvency - a stock or balance perspective

vLiquidity - a flow perspectivevLiquidity - a flow perspective

vLiquidity management involves finding the rightbalance of stocks and flowsvLiquidity management involves finding the rightbalance of stocks and flows

Current Liquidity IndexCurrent Liquidity Index

Cash assets t-1 + CFFO t Cash assets t-1 + CFFO t

CLI = ---------------------------------CLI = ---------------------------------

N/P t-1 + CMLTD t-1 N/P t-1 + CMLTD t-1

$20 + $2,906 $20 + $2,906

CLI = ------------------ = 1.78CLI = ------------------ = 1.78

$1,575 + $71 $1,575 + $71

1992 1993 1994 1995 1992 1993 1994 1995

CLI 3.21 2.65 1.34 1.78CLI 3.21 2.65 1.34 1.78

W.T. Grant’s current liquidity index ran at a deficit. W.T. Grant’s current liquidity index ran at a deficit.

Cash assets t-1 + CFFO t Cash assets t-1 + CFFO t

CLI = ---------------------------------CLI = ---------------------------------

N/P t-1 + CMLTD t-1 N/P t-1 + CMLTD t-1

$20 + $2,906 $20 + $2,906

CLI = ------------------ = 1.78CLI = ------------------ = 1.78

$1,575 + $71 $1,575 + $71

1992 1993 1994 1995 1992 1993 1994 1995

CLI 3.21 2.65 1.34 1.78CLI 3.21 2.65 1.34 1.78

W.T. Grant’s current liquidity index ran at a deficit. W.T. Grant’s current liquidity index ran at a deficit.

LambdaLambda

Initial liquid Total anticipated net cash flow Initial liquid Total anticipated net cash flow

reserve + during the analysis horizonreserve + during the analysis horizon

Lambda = -------------------------------------------------------------------Lambda = -------------------------------------------------------------------

Uncertainty about the net cash flow during theUncertainty about the net cash flow during the

analysis horizonanalysis horizon

Initial liquid Total anticipated net cash flow Initial liquid Total anticipated net cash flow

reserve + during the analysis horizonreserve + during the analysis horizon

Lambda = -------------------------------------------------------------------Lambda = -------------------------------------------------------------------

Uncertainty about the net cash flow during theUncertainty about the net cash flow during the

analysis horizonanalysis horizon

Financial FlexibilityFinancial Flexibility

Sustainable Growth Rate Concept: Sustainable Growth Rate Concept:

Uses = Sources Uses = Sources

New Assets = New Equity + New DebtNew Assets = New Equity + New Debt

gS(A/S) = m(S+gS)(1-d) + m(S+gS)(1-d)(D/E) gS(A/S) = m(S+gS)(1-d) + m(S+gS)(1-d)(D/E)

m(1-d)[1 + (D/E)] m(1-d)[1 + (D/E)]

g = ---------------------------------- g = ----------------------------------

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

.0346 x (1 - .1282) x (1 + 1.4590) .0346 x (1 - .1282) x (1 + 1.4590)

g = ------------------------------------------------- = 23.30% g = ------------------------------------------------- = 23.30%

.3926 - [.0346 x (1 - .1282)(1 + 1.4590)] .3926 - [.0346 x (1 - .1282)(1 + 1.4590)]

calculation uses 1994 data to calculate the sustainable 1995 g.calculation uses 1994 data to calculate the sustainable 1995 g.

Sustainable Growth Rate Concept: Sustainable Growth Rate Concept:

Uses = Sources Uses = Sources

New Assets = New Equity + New DebtNew Assets = New Equity + New Debt

gS(A/S) = m(S+gS)(1-d) + m(S+gS)(1-d)(D/E) gS(A/S) = m(S+gS)(1-d) + m(S+gS)(1-d)(D/E)

m(1-d)[1 + (D/E)] m(1-d)[1 + (D/E)]

g = ---------------------------------- g = ----------------------------------

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

.0346 x (1 - .1282) x (1 + 1.4590) .0346 x (1 - .1282) x (1 + 1.4590)

g = ------------------------------------------------- = 23.30% g = ------------------------------------------------- = 23.30%

.3926 - [.0346 x (1 - .1282)(1 + 1.4590)] .3926 - [.0346 x (1 - .1282)(1 + 1.4590)]

calculation uses 1994 data to calculate the sustainable 1995 g.calculation uses 1994 data to calculate the sustainable 1995 g.

SummarySummary

vChapter introduced basic concepts of:vChapter introduced basic concepts of:

–solvency–solvency

–liquidity–liquidity

–financial flexibility–financial flexibility

vSolvency: an accounting concept comparing assetsto liabilitiesvSolvency: an accounting concept comparing assetsto liabilities

vLiquidity: related to a firm’s ability to pay for itscurrent obligations in a timely fashion withminimal costsvLiquidity: related to a firm’s ability to pay for itscurrent obligations in a timely fashion withminimal costs

vFinancial flexibility: related to a firm’s overallfinancial structure and if financial policies allowsfirm enough flexibility to take advantage ofunforeseen opportunities.vFinancial flexibility: related to a firm’s overallfinancial structure and if financial policies allowsfirm enough flexibility to take advantage ofunforeseen opportunities.