Copyright Copyright 2005 by Thomson Learning, Inc. 2005 by Thomson Learning, Inc. Chapter 2 Chapter 2 Analysis of Solvency, Liquidity, Analysis of Solvency, Liquidity, and Financial Flexibility and Financial Flexibility Order Order Order Order Sale Sale Pa Pa Placed Placed Received Received < Inventory > < Receivable < Inventory > < Receivable Accounts Disbursement Accounts Disbursement < Payable > < < Payable > < Invoice Received Payment S Invoice Received Payment S
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Copyright 2005 by Thomson Learning, Inc. Chapter 2 Analysis of Solvency, Liquidity, and Financial Flexibility Order Order Sale Payment Sent Cash Placed.
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Copyright Copyright 2005 by Thomson Learning, Inc. 2005 by Thomson Learning, Inc.
Chapter 2Chapter 2Analysis of Solvency, Liquidity, and Analysis of Solvency, Liquidity, and Financial FlexibilityFinancial Flexibility
OrderOrder Order Order Sale Sale Payment Sent Payment Sent CashCash PlacedPlaced Received Received ReceivedReceived Accounts CollectionAccounts Collection < Inventory > < Receivable > < Float >< Inventory > < Receivable > < Float >
Time ==>Time ==> Accounts Disbursement Accounts Disbursement
< Payable > < Float >< Payable > < Float > Invoice Received Payment Sent Invoice Received Payment Sent Cash DisbursedCash Disbursed
OrderOrder Order Order Sale Sale Payment Sent Payment Sent CashCash PlacedPlaced Received Received ReceivedReceived Accounts CollectionAccounts Collection < Inventory > < Receivable > < Float >< Inventory > < Receivable > < Float >
Time ==>Time ==> Accounts Disbursement Accounts Disbursement
< Payable > < Float >< Payable > < Float > Invoice Received Payment Sent Invoice Received Payment Sent Cash DisbursedCash Disbursed
Copyright Copyright 2005 by Thomson Learning, Inc. 2005 by Thomson Learning, Inc.
Learning ObjectivesLearning Objectives
Differentiate between solvency and liquidity ratiosDifferentiate between solvency and liquidity ratios Conduct a liquidity analysisConduct a liquidity analysis Assess a firm’s financial flexibility positionAssess a firm’s financial flexibility position
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Financial Statements - Basic Source Financial Statements - Basic Source of Informationof Information
Balance SheetBalance Sheet
Income StatementIncome Statement
Statement of Cash FlowsStatement of Cash Flows
Copyright Copyright 2005 by Thomson Learning, Inc. 2005 by Thomson Learning, Inc.
Solvency MeasuresSolvency Measures
Current RatioCurrent Ratio
Quick RatioQuick Ratio
Net Working CapitalNet Working Capital
Net Liquid BalanceNet Liquid Balance
Working Capital RequirementsWorking Capital Requirements
Copyright Copyright 2005 by Thomson Learning, Inc. 2005 by Thomson Learning, Inc.
Current RatioCurrent Ratio
Current assetsCurrent assetsCurrent ratio = -------------------------Current ratio = ------------------------- Current liabilitiesCurrent liabilities
$8,924$8,924Current ratio = ------------ = 1.00Current ratio = ------------ = 1.00 $8,933$8,933
Copyright Copyright 2005 by Thomson Learning, Inc. 2005 by Thomson Learning, Inc.
Quick RatioQuick Ratio
Current assets - InventoriesCurrent assets - InventoriesQuick ratio = -------------------------------------Quick ratio = ------------------------------------- Current liabilitiesCurrent liabilities
$8,924 - $306$8,924 - $306Quick ratio = ------------------- = .96Quick ratio = ------------------- = .96 $8,933$8,933
Current assets - InventoriesCurrent assets - InventoriesQuick ratio = -------------------------------------Quick ratio = ------------------------------------- Current liabilitiesCurrent liabilities
$8,924 - $306$8,924 - $306Quick ratio = ------------------- = .96Quick ratio = ------------------- = .96 $8,933$8,933
Copyright Copyright 2005 by Thomson Learning, Inc. 2005 by Thomson Learning, Inc.
What is Liquidity?What is Liquidity?
IngredientsIngredients– TimeTime
– AmountAmount
– CostCost
DefinitionDefinition– Having enough financial resources to cover financial obligations Having enough financial resources to cover financial obligations
in a timely manner with minimal costsin a timely manner with minimal costs
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What is Liquidity - ExamplesWhat is Liquidity - Examples
Amount and trend of internal cash flowAmount and trend of internal cash flow
Aggregate available credit linesAggregate available credit lines
Attractiveness of firm’s commercial paper and Attractiveness of firm’s commercial paper and other financial instrumentsother financial instruments
Overall expertise of managementOverall expertise of management
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Liquidity MeasuresLiquidity Measures
Cash Flow From OperationsCash Flow From Operations
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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 theanalysis 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 theanalysis horizonanalysis horizon
Copyright Copyright 2005 by Thomson Learning, Inc. 2005 by Thomson Learning, Inc.
.039977 x (1 - 0.00) x (1 + 1.8834).039977 x (1 - 0.00) x (1 + 1.8834) g = ----------------------------------------------------- = 36.14%g = ----------------------------------------------------- = 36.14% .43426 - [0.039977 x (1 - 0.00)(1 + 1.8834)].43426 - [0.039977 x (1 - 0.00)(1 + 1.8834)]calculation uses 2002 data to calculate the sustainable 2003 g.calculation uses 2002 data to calculate the sustainable 2003 g.
.039977 x (1 - 0.00) x (1 + 1.8834).039977 x (1 - 0.00) x (1 + 1.8834) g = ----------------------------------------------------- = 36.14%g = ----------------------------------------------------- = 36.14% .43426 - [0.039977 x (1 - 0.00)(1 + 1.8834)].43426 - [0.039977 x (1 - 0.00)(1 + 1.8834)]calculation uses 2002 data to calculate the sustainable 2003 g.calculation uses 2002 data to calculate the sustainable 2003 g.
Copyright Copyright 2005 by Thomson Learning, Inc. 2005 by Thomson Learning, Inc.
SolvencySolvency: an accounting concept comparing assets to : an accounting concept comparing assets to liabilities.liabilities.
LiquidityLiquidity: related to a firm’s ability to pay for its : related to a firm’s ability to pay for its current obligations in a timely fashion with minimal current obligations in a timely fashion with minimal costs.costs.
Financial flexibilityFinancial flexibility: related to a firm’s overall financial : related to a firm’s overall financial structure and if financial policies allows firm enough structure and if financial policies allows firm enough flexibility to take advantage of unforeseen opportunities.flexibility to take advantage of unforeseen opportunities.