Spring 2009 NBA 5060

Lecture 6 – Liquidity and Solvency Analysis

1. Liquidity risk

2. Solvency risk

Supplemental note (not discussed in class):

3. Preparing a statement of cash flows from an income statement and

two balance sheets

Change in the syllabus: We will discuss the Just for Feet case on Thursday, Feb. 12. The case
will be handed out in class on Tuesday, Feb. 10.

Lecture 6 Page 1 of 7
Liquidity Risk Analysis

Liquidity risk refers to the ability of a firm to meet its short term
obligations.

Analytical Tools:

Current Ratio = Current Assets / Current Liabilities

Quick Ratio = (Cash + short term investments + AR) / Current liab.

Operating Cash Flow to Current Liabilities

= Cash from operations / Current liabilities

Lecture 6 Page 2 of 7
Long-term solvency risk ratios

Solvency risk refers to the ability of a firm to service its external

debt.

Analytical Tools:

1. Debt and Leverage Ratios: includes debt to equity; liabilities to

equity; net debt to equity; debt to capital; net debt to capital.

2. Interest Coverage Ratios

Income based = (net income + interest exp + tax exp) / interest exp

Cash based = (CFO + interest exp + tax exp) / interest exp

Note: interest expense and

tax expense are used to
approximate interest paid
and taxes paid in the cash
based ratio.

3. Operating cash to capital expenditures = CFO / Capital

Expenditures (acquisitions & purchases of PPE)

Lecture 6 Page 3 of 7
Preparing a statement of cash flows from I/S and B/S

Why is this important?

Recall the fundamental Accounting Equation:

Assets = Liabilities + Equity

Thus: Assetst = Liabilitiest + Equityt

Assetst-1 = Liabilitiest-1 + Equityt-1

and ∆Assets = ∆Liabilities + ∆Equity

∆Cash + ∆Current assets + ∆Non-current assets =

∆Liabilities + ∆Non-current liabilities + ∆Equity

∆Cash = - ∆Current assets - ∆Non-current assets +

∆Current liabilities + ∆Non-current liabilities + ∆Equity

where ∆Non-current assets = Asset Purchases – Asset Sales

+(-) gain(loss) on sale of assets – depreciation expense

∆Equity = Net Income – Dividends paid

+/- stock issued (repurchased)

Lecture 6 Page 4 of 7
Rearranging we get:

∆Cash = Net Income + depreciation - (+) gain (loss) on sale of assets -

∆Current assets + ∆Current liabilities - Asset Purchases + Asset
Sales - ∆Non-current liabilities +/- stock issued (repurchased) -
Dividends paid

In general, because of the fact that assets equal liabilities plus equity, all
changes in the balance sheet other than cash have to be accounted for.
This will ensure your statement of cash flows balances. Then, the only
remaining concern is classifying the changes as operating, investing, or
financing.

Lecture 6 Page 5 of 7
A Skeleton Statement of Cash Flows:

Sample Company
Consolidated Statement of Cash Flows
For year ended Jan. 28, 2000
OPERATING ACTIVITIES
Net Income
Add: Depreciation
Amortization
Change in Def Taxes (net)
Loss (Gain) on Sale of PPE
Decrease (increase) in other assets
Decrease (increase) in AR
Decrease (increase) in Inventory These are the
Decrease (increase) other current assets changes in ‘working
Increase (decrease) in AP capital’ or ‘non-cash
Increase (decrease) in accrued expenses working capital’.
Increase (decrease) in other current liab

Equals: Cash from (used by) Operations

INVESTING ACTIVITIES
Subtract: Net Purchases of Property, Plant & Equip.
Acquisitions net of divestitures

Equals: Cash from (used by) Investing

FINANCING ACTIVITIES
Change in interest bearing debt
Proceeds from issuance of equity (net of
repurchases)
Dividends Paid

Equals: Cash from (used by) Financing Activities

Beginning Cash
Net Change in cash & equivalents (CFO+CFI+CFF)
Ending cash

Lecture 6 Page 6 of 7
 Classification of changes in balance sheet accounts
(some of these can vary in reality):

Operating Investing Financing

Assets
Marketable securities or
investments in securities X
Accounts Receivable X
Inventory X
Other Current Assets X

Property, Plant & Equipment X

Accumulated depreciation X
Other Assets X X
Liabilities and Equity
Accounts Payable X
Notes Payable X
Current portion of long-term debt
X
Other current liabilities X
Long-term debt X
Deferred Taxes (can be asset too) X
Other non-current liabilities X X
Common Stock X
Additional Paid in capital X
Retained Earnings X (Net Inc) X (dividends)
Treasury stock X

When you construct a SCF this way, will it match the actual SCF
reported by the firm? If not, why not?

Lecture 6 Page 7 of 7