1. Copyright  1998 by Harcourt Brace &Company Chapter 2 Analysis of Solvency, Liquidity, and Financial Flexibility Order Order Sale Cash Placed Received Received Accounts Collection Accounts Collection Time ==> Time ==> Accounts Disbursement Accounts Disbursement Invoice Payment Cash Invoice Payment Cash Received Sent Paid Received Sent Paid Order Order Sale Cash Placed Received Received Accounts Collection Accounts Collection Time ==> Time ==> Accounts Disbursement Accounts Disbursement Invoice Payment Cash Invoice Payment Cash Received Sent Paid Received Sent Paid

2. Copyright  1998 by Harcourt Brace &Company Learning Objectives v To develop an understanding of liquidity v Differentiate between solvency and liquidity ratios v Conduct a liquidity analysis v Assess a firm’s financial flexibility position

3. Copyright  1998 by Harcourt Brace &Company Financial Statements - Basic Source of Information v Balance Sheet v Income Statement v Statement of Cash Flows

4. Copyright  1998 by Harcourt Brace &Company Solvency Measures v Current Ratio v Quick Ratio v Net Working Capital v Net Liquid Balance v Working Capital Requirements

5. Copyright  1998 by Harcourt Brace &Company Current Ratio Current assets Current assets Current ratio = ------------------------- Current liabilities Current liabilities $15,338 $15,338 Current ratio = ------------ = 1.54 $9,973 $9,973 1991 1992 1993 1994 1995 1991 1992 1993 1994 1995 Current ratio 1.61 1.71 1.51 1.64 1.54 Current assets Current assets Current ratio = ------------------------- Current liabilities Current liabilities $15,338 $15,338 Current ratio = ------------ = 1.54 $9,973 $9,973 1991 1992 1993 1994 1995 1991 1992 1993 1994 1995 Current ratio 1.61 1.71 1.51 1.64 1.54

6. Copyright  1998 by Harcourt Brace &Company Quick Ratio Current assets - Inventories Current assets - Inventories Quick ratio = ------------------------------------- Current liabilities Current liabilities $15,338 - $14,064 $15,338 - $14,064 Quick ratio = ------------------------ =.13 $9,973 $9,973 1991 1992 1993 1994 1995 1991 1992 1993 1994 1995 Quick ratio.15.24.14.15.13 Current assets - Inventories Current assets - Inventories Quick ratio = ------------------------------------- Current liabilities Current liabilities $15,338 - $14,064 $15,338 - $14,064 Quick ratio = ------------------------ =.13 $9,973 $9,973 1991 1992 1993 1994 1995 1991 1992 1993 1994 1995 Quick ratio.15.24.14.15.13

7. Copyright  1998 by Harcourt Brace &Company Net Working Capital Net working capital = CA - CL Net working capital = $15,338 - $9,973 = $5,365 = $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 Grant’s NWC averaged about $371 million Net working capital = CA - CL Net working capital = $15,338 - $9,973 = $5,365 = $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 Grant’s NWC averaged about $371 million

8. Copyright  1998 by Harcourt Brace &Company NWC and its Component Parts Cash Mkt Sec A/R Inventory Prepaid A/P N/P CMLTD Cash A/R Inventory Prepaid A/P N/P CMLTD Cash A/R Inventory Prepaid A/P N/P CMLTD CA CL CA CL CA CL CA CL CA CL CA CL NWC = CA - CL WCR = A/R + INV +Pre NLB = Cash + M/S NWC = CA - CL WCR = A/R + INV +Pre NLB = Cash + M/S - A/P - N/P - CMLTD Net Working Capital Net Working Capital Working Capital Requirements Net Liquid Balance

9. Copyright  1998 by Harcourt Brace &Company Working Capital Requirements ($900+$14,064+$329) - ($5,907+$365+$1,819) ($900+$14,064+$329) - ($5,907+$365+$1,819) WCR/S = ----------------------------------------------------------- $82,494 $82,494$7,202 = ----------- =.09 = ----------- =.09 $82,494 $82,494 1991 1992 1993 1994 1995 1991 1992 1993 1994 1995 WCR/S.09.09.09.10.09 Grant’s WCR/S ratio averaged.42 Grant’s WCR/S ratio averaged.42 ($900+$14,064+$329) - ($5,907+$365+$1,819) ($900+$14,064+$329) - ($5,907+$365+$1,819) WCR/S = ----------------------------------------------------------- $82,494 $82,494$7,202 = ----------- =.09 = ----------- =.09 $82,494 $82,494 1991 1992 1993 1994 1995 1991 1992 1993 1994 1995 WCR/S.09.09.09.10.09 Grant’s WCR/S ratio averaged.42 Grant’s WCR/S ratio averaged.42

10. Copyright  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) = ($1,837) ($000,000) 1991 1992 1993 1994 1995 Net liquid balance ($413) ($463) ($1,636) ($1,626) ($1,837) Grant’s NLB ran at a deficit Grant’s NLB ran at a deficit Net liquid balance = Cash + Equiv. - (N/P + CMLTD) Net liquid balance = $45 - ($1,795 + $87) = ($1,837) = ($1,837) ($000,000) 1991 1992 1993 1994 1995 Net liquid balance ($413) ($463) ($1,636) ($1,626) ($1,837) Grant’s NLB ran at a deficit Grant’s NLB ran at a deficit

11. Copyright  1998 by Harcourt Brace &Company What is Liquidity? v Ingredients – Time – Amount – Cost v Definition – Having enough financial resources to cover financial obligations in a timely manner with minimal costs

12. Copyright  1998 by Harcourt Brace &Company What is Liquidity - Examples (Ludeman) v Amount and trend of internal cash flow v Aggregate available credit lines v Attractiveness of firm’s commercial paper and other financial instruments v Overall expertise of management

13. Copyright  1998 by Harcourt Brace &Company Liquidity Measures v Cash Flow From Operations (narrow) v Cash Conversion Period (narrow) v Current Liquidity Index (narrow) v Lambda (broad)

14. Copyright  1998 by Harcourt Brace &Company Cash Flow From Operations ($ Billions) 1991 1992 1993 1994 1995 CFFO or OCF $1.29 $1.37 $1.27 $2.19 $2.91 W.T. Grant’s CFFO was a deficit for 8 of its last 10 years. ($ Billions) 1991 1992 1993 1994 1995 CFFO or OCF $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. Wal - Mart’s Cash Flow From Operations

15. Copyright  1998 by Harcourt Brace &Company Cash Conversion Chart Inventory Inventory Cash stocked sold received Days inventory held Days sales outstanding Days inventory held Days sales outstanding Days payables outstanding Cash conversion Days payables outstanding Cash conversion period period Cash Cash disbursed disbursed

16. Copyright  1998 by Harcourt Brace &Company Cash Conversion Period Calculations (Wal-Mart) Cash conversion period = DIH + DSO - DPO (Days) 1991 1992 1993 1994 1995 DIH 84.02 78.55 77.68 76.40 79.57 DSO 6.10 9.15 5.51 4.87 3.98 ------- ------ ------ ------ ------ ------- ------ ------ ------ ------ Operating cycle 90.12 87.70 83.19 81.27 83.55 DPO 38.46 36.74 32.46 28.47 33.42 ------- ------- ------- ------- ------- ------- ------- ------- ------- ------- Cash conversion period 51.66 50.96 50.73 52.80 50.13 Grant’s cash conversion period exceeded 200 days! Cash conversion period = DIH + DSO - DPO (Days) 1991 1992 1993 1994 1995 DIH 84.02 78.55 77.68 76.40 79.57 DSO 6.10 9.15 5.51 4.87 3.98 ------- ------ ------ ------ ------ ------- ------ ------ ------ ------ Operating cycle 90.12 87.70 83.19 81.27 83.55 DPO 38.46 36.74 32.46 28.47 33.42 ------- ------- ------- ------- ------- ------- ------- ------- ------- ------- Cash conversion period 51.66 50.96 50.73 52.80 50.13 Grant’s cash conversion period exceeded 200 days!

17. Copyright  1998 by Harcourt Brace &Company How Much Liquidity is Enough? v Solvency - a stock or balance perspective v Liquidity - a flow perspective v Liquidity management involves finding the right balance of stocks and flows

18. Copyright  1998 by Harcourt Brace &Company Current Liquidity Index Cash assets t-1 + CFFO t Cash assets t-1 + CFFO t CLI = --------------------------------- N/P t-1 + CMLTD t-1 N/P t-1 + CMLTD t-1 $20 + $2,906 $20 + $2,906 CLI = ------------------ = 1.78 $1,575 + $71 $1,575 + $71 1992 1993 1994 1995 1992 1993 1994 1995 CLI 3.21 2.65 1.34 1.78 W.T. Grant’s current liquidity index ran at a deficit. W.T. Grant’s current liquidity index ran at a deficit. Cash assets t-1 + CFFO t Cash assets t-1 + CFFO t CLI = --------------------------------- N/P t-1 + CMLTD t-1 N/P t-1 + CMLTD t-1 $20 + $2,906 $20 + $2,906 CLI = ------------------ = 1.78 $1,575 + $71 $1,575 + $71 1992 1993 1994 1995 1992 1993 1994 1995 CLI 3.21 2.65 1.34 1.78 W.T. Grant’s current liquidity index ran at a deficit. W.T. Grant’s current liquidity index ran at a deficit.

19. Copyright  1998 by Harcourt Brace &Company Lambda Initial liquid Total anticipated net cash flow Initial liquid Total anticipated net cash flow reserve + during the analysis horizon Lambda = ------------------------------------------------------------------- Uncertainty about the net cash flow during the analysis horizon Initial liquid Total anticipated net cash flow Initial liquid Total anticipated net cash flow reserve + during the analysis horizon Lambda = ------------------------------------------------------------------- Uncertainty about the net cash flow during the analysis horizon

20. Copyright  1998 by Harcourt Brace &Company Financial Flexibility Sustainable Growth Rate Concept: Sustainable Growth Rate Concept: Uses = Sources Uses = Sources New Assets = New Equity + New Debt gS(A/S) = m(S+gS)(1-d) + m(S+gS)(1-d)(D/E) gS(A/S) = m(S+gS)(1-d) + m(S+gS)(1-d)(D/E) m(1-d)[1 + (D/E)] m(1-d)[1 + (D/E)] g = ---------------------------------- g = ---------------------------------- (A/S) - {m(1-d)[1 + (D/E)]} (A/S) - {m(1-d)[1 + (D/E)]}.0346 x (1 -.1282) x (1 + 1.4590).0346 x (1 -.1282) x (1 + 1.4590) g = ------------------------------------------------- = 23.30% g = ------------------------------------------------- = 23.30%.3926 - [.0346 x (1 -.1282)(1 + 1.4590)].3926 - [.0346 x (1 -.1282)(1 + 1.4590)] calculation uses 1994 data to calculate the sustainable 1995 g. Sustainable Growth Rate Concept: Sustainable Growth Rate Concept: Uses = Sources Uses = Sources New Assets = New Equity + New Debt gS(A/S) = m(S+gS)(1-d) + m(S+gS)(1-d)(D/E) gS(A/S) = m(S+gS)(1-d) + m(S+gS)(1-d)(D/E) m(1-d)[1 + (D/E)] m(1-d)[1 + (D/E)] g = ---------------------------------- g = ---------------------------------- (A/S) - {m(1-d)[1 + (D/E)]} (A/S) - {m(1-d)[1 + (D/E)]}.0346 x (1 -.1282) x (1 + 1.4590).0346 x (1 -.1282) x (1 + 1.4590) g = ------------------------------------------------- = 23.30% g = ------------------------------------------------- = 23.30%.3926 - [.0346 x (1 -.1282)(1 + 1.4590)].3926 - [.0346 x (1 -.1282)(1 + 1.4590)] calculation uses 1994 data to calculate the sustainable 1995 g.

21. Copyright  1998 by Harcourt Brace &Company Summary v Chapter introduced basic concepts of: – solvency – liquidity – financial flexibility v Solvency: an accounting concept comparing assets to liabilities v Liquidity: related to a firm’s ability to pay for its current obligations in a timely fashion with minimal costs v Financial flexibility: related to a firm’s overall financial structure and if financial policies allows firm enough flexibility to take advantage of unforeseen opportunities.