Chapter 2
Analysis of Solvency, Liquidity,
and Financial Flexibility
Order
Placed
Order
Received
Sale
Cash
Received
Accounts
Collection
< Inventory > < Receivable > < Float >
Time ==>
Accounts
< Payable >
Invoice
Received
Disbursement
<
Float
>
Payment
Sent
Cash
Paid
Copyright  2002 by South-Western, a division of Thomson Learning TM
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

Copyright  2002 by South-Western, a division of Thomson Learning TM
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
Current ratio
1995
1.96
1996
2.08
1997
1.66
1998
1.45
1999
1.72
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Quick Ratio
Current assets - Inventories
Quick ratio = ------------------------------------Current liabilities
$6,339 - $273
Quick ratio = -------------------- = 1.64
$3,695
Quick ratio
1995
1.57
1996
1.63
1997
1.51
1998
1.36
1999
1.64
Copyright  2002 by South-Western, a division of Thomson Learning TM
Net Working Capital
Net working capital = CA - CL
Net working capital = $6,339 - $3,695
= $2,644
($ Millions)
Net working capital
1995
1996
1997
1998
1999
$ 719 $1,018 $1,089 $1,215 $2,644
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NWC and its Component Parts
CA
CL
CA
CL
Cash
Cash
CA
CL
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
Net Working Capital
WCR = A/R + INV +Pre
- A/P - Accruals
=
NLB = Cash + M/S
- N/P - CMLTD
Working Capital
Requirements
+ Net Liquid Balance
Copyright  2002 by South-Western, a division of Thomson Learning TM
Working Capital Requirements
($2,481+$273+$404) - ($2,397+$355+$943)
WCR/S = ----------------------------------------------------------$18,243
($537)
= ----------- = -0.029
$18,243
WCR/S
1995
.055
1996
.082
1997
-.030
1998
-.039
1999
-.029
Copyright  2002 by South-Western, a division of Thomson Learning TM
Net Liquid Balance
Net liquid balance = Cash + Equiv. - (N/P + CMLTD)
Net liquid balance = $3,181 - $0
= $3,181
($ Millions)
Net liquid balance
1995
$527
1996
1997
1998
1999
$586 $1,325 $1,698 $3,181
Copyright  2002 by South-Western, a division of Thomson Learning TM
What is Liquidity?

Ingredients
– Time
– Amount
– Cost

Definition
– “ Having enough financial resources to cover financial
obligations in a timely manner with minimal costs”
Copyright  2002 by South-Western, a division of Thomson Learning TM
What is Liquidity - Examples

Amount and trend of internal cash flow

Aggregate available credit lines

Attractiveness of firm’s commercial paper and
other financial instruments

Overall expertise of management
Copyright  2002 by South-Western, a division of Thomson Learning TM
Liquidity Measures (Narrow
Liquidity)

Cash Flow From Operations
– from Statement of Cash Flows

Cash Conversion Period

Current Liquidity Index

Lambda (also financial flexibility measure; more
on this later)
Copyright  2002 by South-Western, a division of Thomson Learning TM
Cash Flow From Operations
Dell’s Cash Flow From Operations
($ Millions)
CFFO
1995
$243.4
1996
1997
1998
1999
$175.0 $1,362.0 $1,592.0 $2,436.0
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Cash Conversion Chart
Inventory
stocked
Inventory
sold
Days inventory held
Days payables outstanding
Cash
received
Days sales outstanding
Cash conversion
period
Cash
disbursed
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Cash Conversion Period
Calculations
Cash conversion period = DIH + DSO - DPO
(Days)
DIH
DSO
1995
1996
1997
1998
1999
40
37
15
9
7
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
Copyright  2002 by South-Western, a division of Thomson Learning TM
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
Copyright  2002 by South-Western, a division of Thomson Learning TM
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
CLI
1996
1,755.62
1997
33.47
1998
85.00
1999
29.32
Copyright  2002 by South-Western, a division of Thomson Learning TM
Lambda
Initial liquid Total anticipated net cash flow
reserve
+ during the analysis horizon
Lambda = ------------------------------------------------------------------Uncertainty about the net cash flow during the
analysis horizon
Copyright  2002 by South-Western, a division of Thomson Learning TM
Financial Flexibility (one measure in
text; Fitch offers another measure)
Sustainable Growth Rate Concept:
Uses
New Assets
gS(A/S)
=
Sources
= New Equity + New Debt
= 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