LESSON 6 – SUMMARY – LIQUIDITY AND SOLVENCY

Analysis of the financial situation

The concept of Liquidity and Solvency

The traditional approach: the rule of the

minimum solvency

The concept of Working Capital and its role in the

liquidity and solvency

The modern financial equilibrium: the

fundamental equation in Liquidity 01

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BALANCE SHEET ANALYSIS (1/2)

The balance can be viewed as the representation of what the firm

owns (assets) and how it is financed (equity and liabilities).

The assets, however, do not have the same degree of liquidity (of

conversion into cash) and the funds do not have to be paid back in

the same time:

On the assets side, for example, a trade receivable will become available in

cash sooner than an inventory (because this must be sold first and only then it

will become a trade receivable...);

On the funds side, for example, the firm has to pay a trade payable before a 3

year loan.

In a simplified perspective we can make a further breakdown of the

assets and resources: turned into cash and required payment -

within a year and more than a year. 02

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BALANCE SHEET ANALYSIS (2/2)

So we will divide the assets in:

Current assets (≤ 1 year)

Non-current asset (> 1 year)

And the resources in:

Current liability (≤ 1 year)

Non-current liabilities + equity (> 1 year)

To have a balanced financial situation, a firm should

naturally have investments and resources with similar

degrees of liquidity and of being paid in time, respectively.03

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RULE OF MINIMUM FINANCIAL BALANCE AND THE NET PERMANENT CAPITAL (1/2)

We have therefore, only considering the large subdivision until 1

year and more than 1 year, the first rule of balance, called the

minimum financial equilibrium:

Current Assets = Current Liabilities (1) or, equivalent:

Non-current Assets = Non-current Liabilities + Equity (2)

Usually, the resources to be paid in more than 1 year (non-

current liabilities and equity) are named as PERMANENT FUNDS,

in which the word "permanent" only indicates that these

capitals will stay for a long period of time in the firm (note that

the Liabilities will eventually be paid). So we can rewrite the

equation (2):

Non-current Assets = Permanent Funds (3)04

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RULE OF MINIMUM FINANCIAL BALANCE AND THE NET PERMANENT CAPITAL (2/2)

This equation (3) allows us to present the concept of NET PERMANENT CAPITAL (NPC):

Net Permanent Capital = Permanent Funds – Non-current

Assets

Thus, the rule of minimum balance is verified when: NPC = 0

If the NPC is positive, it means that there is an excess of permanent

funds (i.e. to be balanced the firm would not need a so high value in

permanent funds, that is, could have a lower value in long term and

a higher value in current liabilities).

If the NPC is negative, it means that there is a lack of permanent funds.

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LIMITS TO THE BALANCE AND THE CONCEPT OF WORKING CAPITAL (1/6)

If we examine more closely some current assets and liabilities, we

may realize that including all of them in short term (1 year) is

elusive. Although they are short-term values, because they

constantly renew, they have, after all, a long-term permanency on

the firm. Let's look at two examples:

Imagine a company that gives its customers a one month deadline for

these to pay; There is no doubt that every sale that the company

does will generate a short-term credit (trade receivables, current

assets), but as the company is constantly selling, it will have a

permanent trade receivable, i.e. permanently in the current assets

will stay a credit on customers of approximately one month sales.

Similar example, but now on the funds side, we could refer to the

amount in trade payables (current liabilities). 06

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LIMITS TO THE BALANCE AND THE CONCEPT OF WORKING CAPITAL (2/6)

Imagine a store that sells televisions and that for security

reasons want to have always in stock 10 televisions (to not take

the risk of not having TV sets to sell). So, at the same time the

store is selling televisions, is also buying new to keep the

inventory as wished; If it sells 10 televisions per month we can

say that the store has a one month stock (inventory, current

assets), but in reality it has permanently over time an inventory

of 10 televisions.

We have, therefore, a set of values of current assets and

liabilities related to the operating activities of the firm that

actually have a long-term permanency.

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LIMITS TO THE BALANCE AND THE CONCEPT OF WORKING CAPITAL (3/6)

We call them OPERATING NEEDS and OPERATING RESOURCES. The

most relevant are:

Needs Trade Receivables

Inventory

Resources Trade Payables

Government ( from having some time given to pay the VAT and amounts

to Social Security)

The difference between the operating Needs and Resources is called

WORKING CAPITAL (WC):

WC = Operating Needs – Operating Resources 08

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LIMITS TO THE BALANCE AND THE CONCEPT OF WORKING CAPITAL (4/6)

It is important to detail the study of this concept of the Working

Capital. If it is positive (which is the most common situation)

represents a NET investment which must be funded on an ongoing

basis. Let's take a closer look at a very simple example of this fact.

EXAMPLE

Consider a business that starts its activities and will sell 20,000

€ per month;

Assume that its only cost is the merchandise it sells and that

there isn't any margin, i.e., sells at the price of purchase;

Consider that the company works without inventories (purchases

to sell), provides its customers with a credit of 3 months and

gets from its suppliers a credit of 1 month;

Ignore the existence of taxes (VAT in particular).

Let us present a table showing the amounts of cash to be

collected and paid monthly:

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LIMITS TO THE BALANCE AND THE CONCEPT OF WORKING CAPITAL (5/6)

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Month 1

Month 2 Month 3 Month 4

REVENUES COLLECTED - - - 20,000*

COST of GOODS PAID - 20,000** 20,000 20,000

Balance - (20,000) (20,000) -

Acumulated - (20,000) (40,000) (40,000)

* Sales from month 1 will be turned into cash on month 4;

** On month 2 it pays the amount relative to the cost of month 1.

As can be seen the company will accumulate a deficit that touches the 40,000 in month 3 and stabilizes from there. However this value will stay over time, i.e., it is a permanent investment. Represents the value of the company's Working Capital, that is, a value that must be permanently invested so the firm can develop its activity.

LIMITS TO THE BALANCE AND THE CONCEPT OF WORKING CAPITAL (6/6)

Let's take a look at how we would reach the same value (40,000),

using directly the concept of Working Capital. In this case the firm

has only an operating need (trade receivables) and one operating

resource (trade payables).

After the first few months of activity let us look at the values that

the company will permanently have in trade receivables and trade

payables:

Trade Receivables: 60,000 ( 3 months of sales)

Trade Payables: 20,000 (1 month)

Then, the WC will be equal to:

WC = 60,000 -20,000 = 40,000

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THE NEW CONCEPT OF FINANCIAL BALANCE USING THE WC(1/3)

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Understood the concepts of operating needs and resources

(and WC), resuming the equation (3) of the rule of minimum

financial balance (Non-current Assets = Permanent Funds), we

can rewrite it considering now and also these values of current

but permanent assets and liabilities:

Non-current Assets + Operating Needs = Permanent Funds +

Operating Resources

Moving the Operating Resources to the left side:

Non-current Assets + Operating Needs – Operating Resources =

Permanent Funds

THE NEW CONCEPT OF FINANCIAL BALANCE USING THE WC (2/3)

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Using the concept of WC:

Non-current Assets + WC = Permanent Funds

Using the concept of Net Permanent Capital (Permanent Funds – Non-current Assets):

WC = NPC

And thus we have two presentations of the fundamental equation

of financial equilibrium. If that equality does not arise, we will have

a Positive Liquidity or a Negative one; using the first expression:

L = Permanent Funds – (Non-current Assets + WC)

In addition to the equality (desirable) where L = 0, there may be

two distinct situations:

THE NEW CONCEPT OF FINANCIAL BALANCE USING THE WC (3/3)

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Non-current Assets + WC > Permanent Funds

In this case: L < 0.

The permanent capital level is insufficient to cover the longest term assets.

This does not necessarily mean that the company is in financial difficulties.

It may have chosen, for example, to finance the assets with short-term

loans. The problem is that the firm has to regularly renew such funding and

with two risks: don't get the credit at all, anymore, or get it on more

disadvantageous conditions.

Non-current Assets + WC < Permanent Funds

In this case: L > 0.

The firm does not need to have a so large amount of permanent capital. It

can choose better by more short-term financing (lower cost and greater

flexibility).