1
LECTURE 7RISK ANALYSIS
LIQUIDITY AND SOLVENCY
1
Short term liquidity analysis Long term solvency analysis
2
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
3
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
4
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
5
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
6
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
7
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
8
A ratio of 0.40 or higher is common for healthy companies
sliabilities Currentflow cash Operating
9
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
10
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
11
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.
12
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
13
Average cash balance Revenues
Revenues to cash ratio =
Days revenues held in cash = Revenue to cash ratio
365
14
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
15
Long term debt ratio =Long term debt
Long term debt + SE
Debt/Equity ratio =Long term debt
Shareholders’ Equity
Liabilities/Assets =Total liabilitiesTotal assets
16
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
17
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.
18
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
19
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
20
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
21
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?
22
Problem 5.10 Case 5.1
23