1. Copyright  2002 by South-Western, a division of Thomson Learning TM 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  2002 by South-Western, a division of Thomson Learning TM Learning Objectives v Differentiate between solvency, liquidity, and financial flexibility ratios v Recognize that liquidity, broadly defined, includes solvency, narrow liquidity, and financial flexibility v Conduct a solvency analysis v Conduct a liquidity analysis v Assess a firm’s financial flexibility position

3. Copyright  2002 by South-Western, a division of Thomson Learning TM Financial Statements - Basic Source of Information v Balance Sheet v Income Statement v Statement of Cash Flows

4. Copyright  2002 by South-Western, a division of Thomson Learning TM Solvency Measures v Current Ratio v Quick Ratio v Net Working Capital v Net Liquid Balance (really gets at liquidity, too) v Working Capital Requirements

5. Copyright  2002 by South-Western, a division of Thomson Learning TM Current Ratio Current assets Current assets Current ratio = ------------------------- Current liabilities Current liabilities $6,339 $6,339 Current ratio = ----------- = 1.72 $3,695 $3,695 1995 1996 1997 1998 1999 1995 1996 1997 1998 1999 Current ratio 1.96 2.08 1.66 1.45 1.72 Current assets Current assets Current ratio = ------------------------- Current liabilities Current liabilities $6,339 $6,339 Current ratio = ----------- = 1.72 $3,695 $3,695 1995 1996 1997 1998 1999 1995 1996 1997 1998 1999 Current ratio 1.96 2.08 1.66 1.45 1.72

6. Copyright  2002 by South-Western, a division of Thomson Learning TM Quick Ratio Current assets - Inventories Current assets - Inventories Quick ratio = ------------------------------------- Current liabilities Current liabilities $6,339 - $273 $6,339 - $273 Quick ratio = -------------------- = 1.64 $3,695 $3,695 1995 1996 1997 1998 1999 1995 1996 1997 1998 1999 Quick ratio 1.57 1.63 1.51 1.36 1.64 Current assets - Inventories Current assets - Inventories Quick ratio = ------------------------------------- Current liabilities Current liabilities $6,339 - $273 $6,339 - $273 Quick ratio = -------------------- = 1.64 $3,695 $3,695 1995 1996 1997 1998 1999 1995 1996 1997 1998 1999 Quick ratio 1.57 1.63 1.51 1.36 1.64

7. Copyright  2002 by South-Western, a division of Thomson Learning TM Net Working Capital Net working capital = CA - CL Net working capital = $6,339 - $3,695 = $2,644 = $2,644 ($ Millions) 1995 1996 1997 1998 1999 Net working capital $ 719 $1,018 $1,089 $1,215 $2,644 Net working capital = CA - CL Net working capital = $6,339 - $3,695 = $2,644 = $2,644 ($ Millions) 1995 1996 1997 1998 1999 Net working capital $ 719 $1,018 $1,089 $1,215 $2,644

8. Copyright  2002 by South-Western, a division of Thomson Learning TM NWC and its Component Parts Cash Mkt Sec A/R Inventory Prepaid N/P Cash A/R Inventory Prepaid Cash A/R Inventory Prepaid 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 A/PA/PA/P N/P CMLTD N/P CMLTDCMLTD Accruals Accruals Accruals - Accruals - Accruals

9. Copyright  2002 by South-Western, a division of Thomson Learning TM Working Capital Requirements ($2,481+$273+$404) - ($2,397+$355+$943) ($2,481+$273+$404) - ($2,397+$355+$943) WCR/S = ----------------------------------------------------------- $18,243 $18,243 ($537) ($537) = ----------- = -0.029 = ----------- = -0.029 $18,243 $18,243 1995 1996 1997 1998 1999 1995 1996 1997 1998 1999 WCR/S.055.082 -.030 -.039 -.029 ($2,481+$273+$404) - ($2,397+$355+$943) ($2,481+$273+$404) - ($2,397+$355+$943) WCR/S = ----------------------------------------------------------- $18,243 $18,243 ($537) ($537) = ----------- = -0.029 = ----------- = -0.029 $18,243 $18,243 1995 1996 1997 1998 1999 1995 1996 1997 1998 1999 WCR/S.055.082 -.030 -.039 -.029

10. Copyright  2002 by South-Western, a division of Thomson Learning TM Net Liquid Balance Net liquid balance = Cash + Equiv. - (N/P + CMLTD) Net liquid balance = $3,181 - $0 = $3,181 = $3,181 ($ Millions) 1995 1996 1997 1998 1999 Net liquid balance $527 $586 $1,325 $1,698 $3,181 Net liquid balance = Cash + Equiv. - (N/P + CMLTD) Net liquid balance = $3,181 - $0 = $3,181 = $3,181 ($ Millions) 1995 1996 1997 1998 1999 Net liquid balance $527 $586 $1,325 $1,698 $3,181

11. Copyright  2002 by South-Western, a division of Thomson Learning TM 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  2002 by South-Western, a division of Thomson Learning TM What is Liquidity - Examples 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  2002 by South-Western, a division of Thomson Learning TM Liquidity Measures (Narrow Liquidity) v Cash Flow From Operations –from Statement of Cash Flows v Cash Conversion Period v Current Liquidity Index v Lambda (also financial flexibility measure; more on this later)

14. Copyright  2002 by South-Western, a division of Thomson Learning TM Cash Flow From Operations ($ Millions) 1995 1996 1997 1998 1999 CFFO $243.4 $175.0 $1,362.0 $1,592.0 $2,436.0 ($ Millions) 1995 1996 1997 1998 1999 CFFO $243.4 $175.0 $1,362.0 $1,592.0 $2,436.0 Dell’s Cash Flow From Operations

15. Copyright  2002 by South-Western, a division of Thomson Learning TM 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  2002 by South-Western, a division of Thomson Learning TM Cash Conversion Period Calculations Cash conversion period = DIH + DSO - DPO (Days) 1995 1996 1997 1998 1999 DIH 40 37 15 9 7 DSO 57 50 42 44 50 ------- ------ ------ ------ ------ ------- ------ ------ ------ ------ Operating cycle 97 87 57 53 57 DPO 60 41 63 63 62 ------- ------- ------- ------- ------- ------- ------- ------- ------- ------- Cash conversion period 37 46 -6 -10 -5 Cash conversion period = DIH + DSO - DPO (Days) 1995 1996 1997 1998 1999 DIH 40 37 15 9 7 DSO 57 50 42 44 50 ------- ------ ------ ------ ------ ------- ------ ------ ------ ------ Operating cycle 97 87 57 53 57 DPO 60 41 63 63 62 ------- ------- ------- ------- ------- ------- ------- ------- ------- ------- Cash conversion period 37 46 -6 -10 -5

17. Copyright  2002 by South-Western, a division of Thomson Learning TM 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 v Let’s look at a couple of measures that combine the two

18. Copyright  2002 by South-Western, a division of Thomson Learning TM 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 $1,844 + $2,436 $1,844 + $2,436 CLI = -------------------- = 29.32 $146 + $0 $146 + $0 1996 1997 1998 1999 1996 1997 1998 1999 CLI 1,755.62 33.47 85.00 29.32 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 $1,844 + $2,436 $1,844 + $2,436 CLI = -------------------- = 29.32 $146 + $0 $146 + $0 1996 1997 1998 1999 1996 1997 1998 1999 CLI 1,755.62 33.47 85.00 29.32

19. Copyright  2002 by South-Western, a division of Thomson Learning TM 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  2002 by South-Western, a division of Thomson Learning TM Financial Flexibility (one measure in text; Fitch offers another measure) 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)]}.0765 x (1 -.00) x (1 + 2.3008).0765 x (1 -.00) x (1 + 2.3008) g*= ------------------------------------------------- = 270.49% g*= ------------------------------------------------- = 270.49%.3462 - [.0765 x (1 -.00)(1 + 2.3008)].3462 - [.0765 x (1 -.00)(1 + 2.3008)] calculation uses 1998 data to calculate the sustainable 1999 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)]}.0765 x (1 -.00) x (1 + 2.3008).0765 x (1 -.00) x (1 + 2.3008) g*= ------------------------------------------------- = 270.49% g*= ------------------------------------------------- = 270.49%.3462 - [.0765 x (1 -.00)(1 + 2.3008)].3462 - [.0765 x (1 -.00)(1 + 2.3008)] calculation uses 1998 data to calculate the sustainable 1999 g*.

21. Copyright  2002 by South-Western, a division of Thomson Learning TM 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 allow firm enough flexibility to take advantage of unforeseen opportunities.