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
Cash
Sent
Paid
Copyright  1998
by Harcourt Brace &Company
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

Copyright  1998 by Harcourt Brace &Company
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

Working Capital Requirements
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Current Ratio
Current assets
Current ratio = ------------------------Current liabilities
$15,338
Current ratio = ------------ = 1.54
$9,973
Current ratio
1991
1.61
1992
1.71
1993
1.51
1994
1.64
1995
1.54
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Quick Ratio
Current assets - Inventories
Quick ratio = ------------------------------------Current liabilities
$15,338 - $14,064
Quick ratio = ------------------------ = .13
$9,973
Quick ratio
1991
.15
1992
.24
1993
.14
1994
.15
1995
.13
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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
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NWC and its Component
Parts
CA
CL
CA
CL
CA
Cash
Cash
Cash
Mkt Sec
Mkt Sec
Mkt Sec
CL
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 = CA - CL
Net Working Capital
WCR = A/R + INV +Pre
- A/P
Working Capital Requirements
Copyright
NLB = Cash + M/S
- N/P - CMLTD
Net Liquid Balance
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Working Capital
Requirements
($900+$14,064+$329) - ($5,907+$365+$1,819)
WCR/S = ----------------------------------------------------------$82,494
$7,202
= ----------- = .09
$82,494
WCR/S
1991
.09
1992
.09
1993
.09
1994
.10
1995
.09
Grant’s WCR/S ratio averaged
Copyright.42
 1998 by Harcourt Brace &Company
Net Liquid Balance
Net liquid balance = Cash + Equiv. - (N/P + CMLTD)
Net liquid balance = $45 - ($1,795 + $87)
= ($1,837)
($000,000)
Net liquid balance
1991
1992
1993
1994
1995
($413) ($463) ($1,636) ($1,626) ($1,837)
Grant’s NLB ran at a deficit
Copyright  1998 by Harcourt Brace &Company
What is Liquidity?

Ingredients
–
–
–

Time
Amount
Cost
Definition
–
Having enough financial resources to cover financial
obligations in a timely manner with minimal costs
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What is Liquidity Examples (Ludeman)

Amount and trend of internal cash flow

Aggregate available credit lines

Attractiveness of firm’s commercial paper and
other financial instruments

Overall expertise of management
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Liquidity Measures

Cash Flow From Operations
(narrow)

Cash Conversion Period
(narrow)

Current Liquidity Index
(narrow)

Lambda
(broad)
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Cash Flow From
Operations
Wal - Mart’s Cash Flow From Operations
($ Billions)
CFFO or OCF
1991 1992 1993 1994 1995
$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.
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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 (Wal-Mart)
Cash conversion period = DIH + DSO - DPO
(Days)
DIH
DSO
1991
84.02
6.10
------Operating cycle
90.12
DPO
38.46
------Cash conversion period 51.66
1992
78.55
9.15
-----87.70
36.74
------50.96
1993
77.68
5.51
-----83.19
32.46
------50.73
1994
1995
76.40 79.57
4.87
3.98
------ -----81.27 83.55
28.47 33.42
------- ------52.80 50.13
Grant’s cash conversion period exceeded 200 days!
Copyright  1998 by Harcourt Brace &Company
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
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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
CLI
1992
3.21
1993
2.65
1994
1.34
1995
1.78
W.T. Grant’s current liquidity index ran at a deficit.
Copyright  1998 by Harcourt Brace &Company
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  1998 by Harcourt Brace &Company
Financial Flexibility
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)]}
.0346 x (1 - .1282) x (1 + 1.4590)
g = ------------------------------------------------- = 23.30%
.3926 - [.0346 x (1 - .1282)(1 + 1.4590)]
calculation uses 1994 data to calculateCopyright
the sustainable
1995 g.
 1998 by Harcourt Brace &Company
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.

Copyright  1998 by Harcourt Brace &Company