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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