LECTURE 7

RISK ANALYSIS
LIQUIDITY AND SOLVENCY

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Short term liquidity analysis

Long term solvency analysis

Liquidity refers to the companys ability to

meet short term obligations
Liquidity is the ability to convert assets into
cash or to obtain cash

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

Cash + Marketable securities + Receivables

Current liabilities

This ratio provides information about an almost

worst-case situationthe firms 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.

Operating cash flow

Current liabilitiess

A ratio of 0.40 or higher is common for

healthy companies

Receivables turnover =

Days receivables
outstanding

Net sales on credit

Average accounts receivable
365

Receivables turnover

A measure of how many times a company

converts its receivables into cash each year

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Inventory turnover =

Cost of goods sold

Average inventory

Days inventory held =

365
Inventory turnover

Inventory turnover: A measure of the number

of times merchandise inventory is sold and
replaced during the year.

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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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Purchases
A/P turnover =
Average accounts payable
Days A/P outstanding =

365
A/P turnover

Measures the extent accounts payable represent

current and not overdue obligations

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Revenues to cash ratio =

Days revenues held in cash =

Revenues
Average cash balance
365
Revenue to cash ratio

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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 =

Debt/Equity ratio =

Liabilities/Assets =

Long term debt

Long term debt + SE
Long term debt
Shareholders Equity
Total liabilities
Total assets

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Debt ratios measure the amount of

liabilities particularly long term debt in a
firms 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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Interest coverage =

NI + Interest exp + Income tax

exp + Minority interest
Interest expense

A common measure of the ability of a firm

to cover interest and provide protection to
the long-term creditors.
High correlation between earningscoverage measures and default rate on
debt

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Operating cash flow

to total liabilities =

Cash flow from operations

Average total liabilities

A measure of a firms ability to generate

cash flow from operations to service debt
A ratio of 0.20 or higher is common for
healthy companies

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Operating cash flow to

capital expenditure =

Cash flow from operations

Capital expenditure

A measure of a firms ability to generate

cash flow from operations in excess of the
capital expenditures needed to maintain
and build plant capacity.

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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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