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LECTURE 7RISK ANALYSIS

LIQUIDITY AND SOLVENCY

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Short term liquidity analysis Long term solvency analysis

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Liquidity refers to the company’s ability to meet short term obligations

Liquidity is the ability to convert assets into cash or to obtain cash

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Working capital is:◦ Defined as the excess of current assets over

current liabilities◦ Widely used measure of short-term liquidity◦ Deficient when current liabilities exceed current

assets◦ In surplus when current assets exceed current

liabilities◦ A margin of safety for creditors◦ A liquid reserve to meet contingencies and

uncertainties Working capital is relevant when related to other variables

such as sales and total assets

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Level of resources available to meet short term commitments◦ Current ratio◦ Quick ratio◦ Operating cash flow to current liabilities

Working capital required to the level of sales generated◦ Accounts receivable turnover◦ Inventory turnover◦ Accounts payable turnover◦ Revenues to cash ratio

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Rule of Thumb Analysis (2:1)> 2:1 superior coverage of current

liabilities (but not too high, suggesting inefficient use of resources and reduced returns)

< 2:1 deficient coverage of current liabilities

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Two useful tools in analyzing the current ratio◦ Trend analysis -- components of working capital and the

current ratio are converted to indexes and examined over time

◦ Common-size analysis -- composition of current assets is examined over time

Problems with interpretation of current ratio◦ Increase/decrease of equal amount in both current

assets and current liabilities◦ A very high current ratio may accompany unsatisfactory

business conditions while a falling ratio may accompany profitable operations

◦ Window dressing

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This ratio provides information about an almost worst-case situation—the firm’s ability to meet its current obligations even if none of the inventory can be sold.

As a rule of thumb, an acid-test ratio of 1.0 is considered indicative of adequate liquidity.

liabilities Currentsecurities Marketable + Receivables+Cash

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A ratio of 0.40 or higher is common for healthy companies

sliabilities Currentflow cash Operating

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A measure of how many times a company converts its receivables into cash each year

receivable accounts Averagecredit on sales NetReceivables turnover =

Days receivables outstanding =

Receivables turnover 365

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Inventory turnover: A measure of the number of times merchandise inventory is sold and replaced during the year.

inventory Averagesold goods of CostInventory turnover =

Days inventory held =365

Inventory turnover

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Lower inventory compared to sales means less needs to be financed by debt or equity

BUT… risk of not having enough inventory to meet

demand risk of out of stock situation with delay in

receiving raw materials or finished product and lost sales.

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Measures the extent accounts payable represent current and not overdue obligations

Days A/P outstanding =365

A/P turnover

A/P turnover =Purchases

Average accounts payable

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Average cash balance Revenues

Revenues to cash ratio =

Days revenues held in cash = Revenue to cash ratio

365

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Solvency -- long-run financial viability and its ability to cover long-term obligations

Solvency ratios◦ Debt ratios◦ Interest coverage◦ Operating cash flow to total liabilities◦ Operating cash flow to capital expenditures

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Long term debt ratio =Long term debt

Long term debt + SE

Debt/Equity ratio =Long term debt

Shareholders’ Equity

Liabilities/Assets =Total liabilitiesTotal assets

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Debt ratios measure the amount of liabilities particularly long term debt in a firm’s capital structure.

The higher this proportion, the greater the long term solvency risk

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Leverage: use of debt to increase net income

Leverage:◦ Magnifies both managerial success (profits) and

failure (losses)◦ Increases risks◦ Limits flexibility in pursuing opportunities◦ Decreases creditors’ protection against loss

Companies with leverage are said to be trading on the equity — implying a company is using equity financing to obtain debt financing in a desire to reap returns above the cost of debt.

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A common measure of the ability of a firm to cover interest and provide protection to the long-term creditors.

High correlation between earnings-coverage measures and default rate on debt

Interest coverage =

NI + Interest exp + Income tax exp + Minority interest

Interest expense

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A measure of a firm’s ability to generate cash flow from operations to service debt

A ratio of 0.20 or higher is common for healthy companies

Operating cash flow to total liabilities =

Average total liabilities Cash flow from operations

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A measure of a firm’s ability to generate cash flow from operations in excess of the capital expenditures needed to maintain and build plant capacity.

Operating cash flow to capital expenditure =

Capital expenditure Cash flow from operations

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Does the company have enough debt? Is it using potential benefits of debt?

Does the company have too much debt given its business risk? What type of debt covenant restrictions does the firm face? Any potential of financial distress?

What is the company doing with the borrowed funds? Investing in working capital or fixed assets? Are these investments profitable?

Is the company borrowing money to pay dividends? Any justification?

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Problem 5.10 Case 5.1

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