1. Dr. Clive Vlieland-Boddy
Liquidity & Leverage
Dr. Clive Vlieland-Boddy 1

2. 2

3. Liquidity Ratios WHO CARES?
Measure the short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash.
WHO CARES?
All stakeholders 3

4. 4

5. Proper Debt Structure 5

6. Monitor Financial Position
Measure 6

7. Monitor Financial Position
What Gets Measured Gets Managed
and
What Gets Managed
Gets Done! 7

8. Learning Objectives
Differentiate between solvency and liquidity ratios
Conduct a liquidity analysis
Assess a firm’s financial flexibility position
Consider a firm’s liquidity, broadly defined, as a combination of its solvency, liquidity, and financial flexibility
Appreciate capital structure theory 8

9. Financial Leverage and Risk
LEV is the other component of ROE
Is Debt a bad thing?
Given that increases in financial leverage increase ROE, why are all companies not 100% debt financed? 9

10. Liquidity and Solvency Measures
Liquidity refers to cash: how much we have, how much is expected, and how much can be raised on short notice.
Solvency refers to the ability to meet obligations; primarily obligations to creditors, including lessors. 10

11. Ratios
Defined:
One number divided by another to express a relationship:
Expresses either as- %
Ratio of say 2:1
Or in a $ sum say $3 per share. 11

12. Ratios Be Selective
Now is the time to become familiar with financial ratios
Select ratios that help focus attention on the most critical areas.
Ratio analysis can be done on
Historical
Current
Projected information 12

13. Balance Sheet Discussion questions
Judgments are made based on balance sheets.
What is a “good” balance sheet?
What is a “good” financial situation? 13

14. Balance Sheet Analysis
To remember. . .
Basic equations
 Assets = Debt + Equity
 Assets minus debts = equity
 Assets - equity = debt 14

15. Liquidity 15

16. How Liquid Is the Firm?
Liquidity measures the firm’s ability to pay its bills on time. It indicates the ease with which non-cash assets can be converted to cash to meet the financial obligations.
A liquid asset is one that can be converted quickly and routinely into cash at the current market price. 16

17. Solvency An accounting concept comparing assets to liabilities.
An enterprise is solvent if it can pay its debts as they fall due.
Otherwise it is classed as “insolvent” and is either entering bankruptcy or in very difficult situation. 17

18. Solvency Ratios WHO CARES?
Measure the ability of the enterprise to survive over a long period of time
WHO CARES?
All Stakeholders 18

19. Financial Flexibility
Related to a firm’s overall financial structure and whether financial policies allow firm enough ability to take advantage of unforeseen opportunities.
There are always opportunities. If the funds are available then they can be taken. 19

20. Gearing or Leverage
This represents the balance between debt and equity capital.
The more debt a company takes on it is becoming more highly geared. 20

21. Gearing This is an efficiency ratio
Looks at the relationship between borrowing and Non Current Assets
Gearing Ratio = Long term loans / Capital employed x 100
The higher it is the greater the risk the business is under if interest rates increase 21

22. Evaluating Liquidity Liquidity is measured by two approaches:
Comparing the firm’s current assets and current liabilities
Examining the firm’s ability to convert accounts receivables and inventory into cash on a timely basis 22

23. Analyzing Liquidity 8
Liquidity refers to the solvency of the firm's overall financial position, i.e. a "liquid firm" is one that can easily meet its short-term obligations as they come due.
A second meaning includes the concept of converting an asset into cash with little or no loss in value. 23

24. Analyzing Activity
Activity is a more sophisticated analysis of a firm's liquidity
Evaluating the speed with which certain accounts are converted into sales or cash.
Also measures a firm's efficiency 24

25. Solvency Measures Cash Ratio Current Ratio Quick Ratio
Net Working Capital
Net Liquid Balance
Working Capital Requirements 25

26. Measuring Short Term Liquidity
Compare a firm’s current assets with current liabilities
Cash Ratio
Current Ratio
Acid Test or Quick Ratio 26

27. Cash Ratio Indicates short-term debt-paying ability (cash basis)
Current Liabilities 27

28. Cash Ratio
Looks at the ability of the enterprise to pay current liabilities just from available cash.
It is little used but is useful for companies in real financial difficulty. 28

29. Current Ratio Current ratio looks at the liquidity of the business
Looks at the ratio between Current Assets and Current Liabilities
Ideal level – approx 1.5 : 1 (Preferably 2:1)
Need enough current assets to cover current liabilities
If its too high means too much invested in current assets
If its too low you run the risk of not being able to meet current liabilities and could have liquidity problems
Buts some industries have a negative Current Ratio like supermarkets. 29

30. The Current Ratio Current Ratio Balance Sheet Ratios Liquidity Ratios
Current Assets
Current Liabilities
Balance Sheet Ratios
Liquidity Ratios
Shows a firm’s ability to cover its current liabilities with its current assets. 30

31. Example 1
Company has Current Assets of $200,000 and Current Liabilities of $100,000
Its Current Ratio would therefore be:
200,000 = 2:1
100,000 31

32. Financial Leverage Ratio Comparisons-An Example
Current Ratio
Company Industry
2:1 2:1
2: :1
Year
2010
2009
2008
Company has an average Current
Ratio to the industry average. 32

33. Acid / Quick Ratio
Acid test ratio is another way of looking at liquidity
It has been argued that stock takes a while to convert to cash so a more realistic ratio would ignore stock
(Current assets – stock) : liabilities
1:1 seen as ideal
Again if it is too high means that the business is very liquid – may be able to use the cash for other activities to increase performance
If it is too low then the business may face working capital problems
Some types of business need more cash than others so acid test would be expected to be higher 33

34. Current Assets - Inventories
Acid or Quick Ratio
Acid-Test (Quick)
Current Assets - Inventories
Current Liabilities
Balance Sheet Ratios
Liquidity Ratios
Note that Inventories are deducted as they normally take some months to convert into cash. There may be other Current Assets that need to be included.
Shows a firm’s ability to meet current liabilities with its most liquid assets. 34

35. Example 2
Company has Current Assets of $200,000 of which $80,000 were inventories, and Current Liabilities of $100,000
Its Acid or Quick Ratio would therefore be:
200,000-80,000 = 1.2:1
100,000 35

36. Financial Leverage Ratio Comparisons-An Example
Quick (Acid) Ratio
Company Industry
1.2:1 1:1
Year
2010
2009
2008
Company has a higher than average quick
Ratio relative to the industry average. 36

37. Net Working Capital
This is the difference between Current Assets and Current Liabilities.
Current Assets – Current Liabilities 37

38. Example 3
Company has Current Assets of $200,000 and Current Liabilities of $100,000
Its Net Working Capital would therefore be:
200, ,000 = 100,000 38

39. Leverage Ratios 39

40. Measuring Ability to Pay Debt
The debt ratio indicates the proportion
of assets financed with debt.
Total liabilities ÷ Total assets 40

41. Financial Leverage Ratios
Debt-to-Equity
Total Debt
Shareholders’ Equity
Balance Sheet Ratios
Financial Leverage
Ratios
Shows the extent to which the firm is financed by debt. 41

42. Example 4 Debt of $900,000 and Equity of $1,000,000
Total Long Term Debt = 900,000 = .9
Total Equity ,000,000
Assuming that 2009 was .88 and 2009 was .81 then we can compare to the industry. 42

43. Financial Leverage Ratio Comparisons-An Example
Debt-to-Equity Ratio
Company Industry
Year
2010
2009
2008
Company has average debt utilization
relative to the industry average. 43

44. Financial Leverage Ratios
Debt-to-Total-Assets
Total Debt
Total Assets
Balance Sheet Ratios
Financial Leverage
Ratios
Shows the percentage of the firm’s assets that are supported by debt financing. 44

45. Example 5 Total debt of $900,000 to Total Assets of $2,500,000
Assuming that 2009 was .38 and 2009 was .37
then we can compare to the industry. 45

46. Financial Leverage Ratio Comparisons-An Example
Debt-to-Total-Asset Ratio
Company Industry
Year
2010
2009
2008
Company has a lower than average debt
Utilization relative to the industry average. 46

47. Financial Leverage Ratios
Total Capitalization
Total Debt
Balance Sheet Ratios
(i.e., LT-Debt + Equity)
Financial Leverage
Ratios
Shows the relative importance of long-term debt to the long-term financing both debt and equity of the firm. 47

48. Example 6 Debt of $900,000 and Equity of $1,000,000
Total Long Term Debt = 900,000 = .47
Total Capitalisation ,900,000
Assuming that 2009 was .49 and 2009 was .51 then we can compare to the industry. 48

49. Financial Leverage Ratio Comparisons
Total Capitalization Ratio
Company Industry
Year
2010
2009
2008
The Company has a below average long-term
debt Utilization relative to the industry average. 49

50. Interest Coverage
This is an excellent way to assess the ability of an enterprise or even an individual’s ability to service debt.
If you bought an apartment for €220k using €200k of loan financing at 5%. If you earnings are €10,000 per annum, you would only be able to pay the interest. In other words once coverage. That is not healthy!. However if you earned €50,000 then it is 5 times covered. 50

51. Interest Coverage Ratio
EBIT
Interest Charges
Income Statement
Ratios
Coverage Ratios
Indicates a firm’s ability to cover interest charges. 51

52. Times Interest Earned Ratio (TIE) Is the same as Interest Coverage52

53. Example 7
Debt of $900,000 with interest for the year of $70,000 and EBIT of $400,000
EBIT = 400,000 = 5.71
Interest 70,000
Assuming that 2009 was 5.55 and 2009 was 5.51 then we can compare to the industry. 53

54. Coverage Ratio Comparisons
Interest Coverage Ratio
Year
2010
2009
2008
Company Industry
The company has a higher but improving
Average interest coverage relative to the
industry average. 54

55. I’m ready for some leisure time.
Bye for now!
I’m ready for some leisure time.
Please ensure you
Prepare for next session 55