7. Liquidity and Solvency ratios Flashcards
- Financial ratio analysis identifies key relationships between the components of the financial statements.
- To interpret ratios correctly, the analyst must have:
ü A general understanding of the company and its environment
ü Financial data for several years or for several companies
ü An understanding of the data underlying the numerator and denominator.
• No single ratio gives the whole picture!
• Performing analysis:
Begin with information about:
ü The company
ü The industry
Use ratios to compare current year to:
ü Prior-years
ü The industry comparable
• A ratio might signal that something is wrong, but doesn’t identify the problem. Analysis of the figures is necessary.
• Red flags in Financial Statement analysis:
Ø Earnings problems
Ø Cash flow reduction
Ø Too much debt
Ø Inability to collect receivables
Ø Build-up inventories
Ø Negative trends of sales, margins, inventory and receivables…
• Liquidity is the amount of liquid assets that are available to pay expenses and debts as they become due. 到期
The most liquid asset is cash.
- Liquidity ratios measure a company’s ability to pay debt obligations through the calculation of metrics.
- Current liabilities (short term debts) are analyzed in relation to current assets (short term liquidity) to evaluate the coverage of short-term debts in an emergency.
- Creditors are primarily concerned with a company’s ability to repay its debts, they want to see there is enough cash and equivalents available to meet the current portions of debt.
- Investors are typically more concerned with the overall health of the business and how it can grow in the future; companies that struggle with liquidity usually have difficulties to increase performance because short-term funding isn’t available.
Working capital is a “financial safety stock” that allow to compensate eventual imbalances or unexpected events that may be produced during the cash cycle
- Measures ability to pay current liabilities with current assets
- It’s also important to understand the types of current assets that the company has and how quickly these can be converted into cash.
- A higher current ratio indicates a stronger financial position
Ø The most successful firms operate with current ratios between 1.20 and 1.50.
It’s not healthy if its current ratio is less than 1.0
- However, one limitation of using ratios emerges when comparing different companies.
- Business operations can differ substantially between industries, comparing the current ratios among companies in different industries will not necessarily lead to any productive insight.
Ø Current ratio example:
ØCharlie’s Skate Shop sells ice-skating equipment. Charlie is applying for a loan to help fund his dream of building an indoor skate rink.
ØCharlie’s bank asks for his balance sheet so they can analyze his current debt level.
ØHe reported $100,000 of current liabilities and only $25,000 of current assets.
ØCharlie’s current ratio would be calculated like this: 0.25 = $25,000 / $100,000
vThis shows that Charlie’s Skate Shop is highly leveraged and highly risky.
vBanks would prefer a current ratio of at least 1 or 2, so that all the current liabilities would be covered by the current assets.
vSince Charlie’s ratio is so low, it is unlikely that he will get approved for his loan
- Shows ability to pay all current liabilities if they come due immediately (quickly)
- It is more conservative than the current ratio because it excludes inventory, which generally are more difficult to turn into cash.
- Inventory is generally considered to be less liquid than these other current assets.
- A higher “quick ratio” means a more liquid current position.
- The quick ratio measures the dollar amount of liquid assets available for each dollar of current liabilities.
- The higher the quick ratio, the better the company’s liquidity position. Also known as the “acid-test ratio” or “quick assets ratio.”
•A rule of thumb is that a “quick ratio” greater than 1.0 means that a company is sufficiently able to meet its short-term obligations.
Ø Carole’s Clothing Store is applying for a bank loan to remodel the storefront.
Ø Carole’s balance sheet includes the following accounts:
ü Cash: $10,000
ü Accounts receivable: $6,000
ü Inventory: $5,000
ü Short-term stock investments: $1,000
ü Current liabilities: $15,000
Quick Ratio = ($10.000 + $6.000 + $1.000) / $15.000 = 1.13, also
Quick Ratio = ($22.000 - $5.000) / $15.000 = 1.13
v Carole’s “quick ratio” is 1.13. This means that Carole can pay off all of her current liabilities with quick assets and still have some quick assets left over.
v It is likely that she will get approved for his loan.
- Measures a firm’s ability to pay off its current liabilities with only cash and cash equivalents.
- The cash ratio is much more restrictive than the current ratio or quick ratio because no other current assets can be used to pay off current debt - only cash and equivalents.
- Creditors like the fact that inventory and accounts receivable are left out of the equation because both of these accounts are not guaranteed to be available for debt servicing.
Solvency is the ability of a company to meet its long-term financial obligations.
- To be considered solvent, the value of a company assets, must be greater than the sum of its debt obligations.
- Companies that meet their debt obligations as they fall due are “solvent”.
- Insolvency is a legal term used when a company is unable to repay the debts that it owes.
• Going concern is an accounting concept used when preparing financial statements. It assumes that a company will continue to operate with no intention or need to stop trading. 持续经营
- Creditors are the most likely to suffer financial losses if a company has insufficient assets to pay its liabilities.
- Insolvency affects other stakeholders. Employees will likely lose their jobs and may not receive redundancy payments.
- Shareholders may lose part or all of their investment.
- Customers may also be affected
- Company’s directors have a legal duty to ‘promote the success of the company’. This includes the need to maintain business solvency and act when there is a risk of insolvency.
- A company’s directors have a legal obligation to ensure that the company does not continue to trade if it is insolvent.
- Even when there is a threat of insolvency, the directors are required to consider their duty to protect the interests of creditors.
- Warning indicators may give directors the time needed to secure alternative sources of cash or change company strategy/the business model.
- “Going concern” refers to a company’s ability to continue functioning as a business entity.
- Financial statements are prepared on the assumption that the entity is a going concern, meaning it will continue in operation for the foreseeable future, and:
Øthe company will be able to realize assets, discharge liabilities and obtain refinancing (if necessary) in the normal course of operations,
Øwith neither the intention nor the necessity of liquidation or ceasing trading.
Øassets and liabilities are recorded on the basis that the entity will be able to realize its assets, discharge its liabilities
- A going concern statement is a directors’ judgements about the ability of the company to continue operating into the ‘foreseeable future’
- However, whilst it may be correct at the time the accounts are signed, it provides no guarantee of longevity
ØThe pace of change in most companies means that a gap of 12 months between reporting is too long to provide any meaningful insight into the changing trading position of a business.
ØAdditionally, for external stakeholders such as suppliers, reported financial information may not be available until seven or nine months after the year ends.
- 审计员 The auditor has a responsibility to evaluate whether there is substantial doubt about the entity’s ability to continue as a going concern, for a reasonable period.
- The auditor’s evaluation is based on his/her knowledge of relevant conditions and events that exist at or have occurred prior to the date of the auditor’s report
- If the auditor believes there is substantial doubt about the entity’s ability to continue as a going concern for a reasonable period, he/she should:
Øobtain information about management’s plans that are intended to mitigate the effect of such conditions or events, and
Øassess the likelihood that such plans can be effectively implemented.
- Solvency is the ability of a company to meet its long-term financial obligations
- Reminder…different ways to finance operations:
Ways to Finance Operations:
• By retained earnings:
üThe firm generates enough cash to buy the necessary assets
üLow risk strategy
üCompany expansion is limited by the past and current earnings…
• By issuing stock:
üNo liability or interest expense is created
üLow risk, but more costly (company control, board of directors, dividends, etc.)
• By issuing debt:
üNo fear to “lose control” of the firm
üUsually, earnings > interest expense
üBut…creating debt puts the firm at risk
- Indicates whether a company’s cash flow is sufficient to meet its short-term and longterm liabilities.
- The lower solvency ratio, the greater the probability of default （违约）on its debt obligations
- “PAT + Depreciation & Amortization” is a quick approach to CFO.
- Measuring cash flow rather than net income is a better determinant of solvency, especially for companies with large amount of depreciation.
- Measures the amount of assets that are financed by owners’ investments.
- How much of the total company assets are owned by the investors or after all of the liabilities are paid off.
• How leveraged the company is with debt: 债务杠杆 how much of a firm’s assets were financed by investors.
• The percentage of assets financed with debt.
ØRatio of 1 reveals that debt has financed all the assets.
ØRatio of 0.5 means that debt finances half of the assets.
- Higher the ratio, greater the pressure to pay interest and principal.
- 破产 Bankruptcies occur from high debt ratio…
- Indicates how much debt a company is using to finance its assets relative to the shareholders’ equity.
- More specifically, it reflects the ability of shareholder equity to cover all outstanding debts in the event of a business downturn.
- A lower debt to equity ratio usually implies a more financially stable business; companies with a higher debt to equity ratio are considered more risky to creditors and investors.
- Financial leverage is the degree to which a company uses debt.
- Is a debt ratio used to determine how easily a company can pay interest on outstanding debt.
- It measures the margin of safety a company has for paying interest during a given period.
- A company’s ability to meet its interest obligations is an aspect of a company’s solvency.
