Liquidity and solvency PDF Imprimare Email

Liquidity and solvency

The table below contains the financial balance sheet of a company over a 2 – year period:

Financial balance sheet

1

2

Nr.

Assets

Year 1

Year 2

1

Intangible assets

10,000

10,000

2

Tangible assets

50,000

190,000

3

Financial assets

20,000

20,000

4

Fixed assets

80,000

220,000

5

Inventories

50,000

25,000

6

Accounts receivable

80,000

35,000

… 7

Costumer receivables

70,000

30,000

… 8

Other receivables

10,000

5,000

9

Cash and cash equivalents

130,000

20,000

10

a) Short term investments

50,000

5,000

11

b) Cash

80,000

15,000

12

Current assets

260,000

80,000

13

Total assets

340,000

300,000

 

 

 

 

Nr.

Equity and Liabilities

Year 1

Year 2

1

Equity

250,000

160,000

2

Long - term debt

10,000

30,000

… 3

Financial long - term debt

10,000

30,000

… 4

Non - financial long - term debt

 

 

5

Long - term capital

260,000

190,000

6

Current liabilities

80,000

110,000

… 7

Financial short - term debt

5,000

15,000

… 9

Non - financial short - term debt

75,000

95,000

… - 10

Accounts payable

55,000

75,000

… - 11

Other operating debt

20,000

20,000

12

Total debt

90,000

140,000

13

Total equity and liabilities

340,000

300,000

 

 

Extract from the profit and loss account

Nr.

Incomes and expenses

Year 1

Year 2

1

Sales

600,000

650,000

2

Fixed operating expenses

 

 

3

Variable operating expenses

 

 

4

Depreciation

5,000

20,000

5

Net operating profit / loss

30,000

32,000

6

Interest

1,500

4,500

7

Net profit / loss

25,000

23,000

 

Extract of the cash flow statement

Nr.

Other information

Year 1

Year 2

1

Long - term loans principal payements

5,000

15,000

2

Long - term loans interest payements

1,500

4,500

3

Dividends

10,000

15,000

4

Duration of the period

360

360

 

 

Tasks: Evaluate the liquidity and solvency of the company for the first 2 years.

Steps to follow:

1. Calculate the financial ratios that reflect information about the liquidity and solvency for both years.

2. Evaluate the liquidity and solvency of the company for year 1 by comparing the calculated values of the ratios to the optimum values.

3. Evaluate the liquidity and solvency of the company for year 2 by comparing the calculated values of the ratios to the optimum values.

4. Analyze the dinamics of the ratios.

5. Specify the causes of the dinamics.

6. Offer improvement solutions for year 3.

 

 


 

1.      Calculation of the liquidity and solvency ratios for year 1 and year 2

Nr.crt.

Liquidity

Year 1

Year 2

1

Current assets

260,000

80,000

2

Current assets absolute deviation

-

-180,000

3

Current assets growth index

-

30.8%

4

Current assets growth rate

-

-69.2%

5

Current liabilities

80,000

110,000

6

Current liabilities absolute deviation

-

30,000

7

Current liabilities growth index

-

137.5%

8

Current liabilities growth rate

-

37.5%

9

Current ratio

3.25

0.73

10

Current ratio growth index

-

22.4%

 

image001

 

Nr.crt.

Liquidity

Year 1

Year 2

1

Current assets - Inventories

210,000

55,000

2

Current liabilities

80,000

110,000

3

Quick ratio

2.63

0.50

4

Quick ratio growth index

-

19.0%

 

image003

 

Nr.crt.

Liquidity

Year 1

Year 2

1

Current assets - Inventories - Accounts receivable

130,000

20,000

2

Current liabilities

80,000

110,000

3

Spot ratio

1.63

0.18

4

Spot ratio growth index

-

11.2%

 

image005

 

 

 

 

 

Nr.crt.

Solvency

Year 1

Year 2

1

Total assets

340,000

300,000

2

Total assets absolute deviation

-

-40,000

3

Total assets growth index

-

88.2%

4

Total assets growth rate

-

-11.8%

5

Total debt

90,000

140,000

6

Total debt absolute deviation

-

50,000

7

Total debt growth index

-

155.6%

8

Total debt growth rate

-

55.6%

9

Solvency ratio

378%

214%

10

Solvency ratio growth index

-

56.7%

 

image007

 

Nr.crt.

Solvency

Year 1

Year 2

1

Net operating profit / loss

30,000

32,000

2

Net operating profit / loss absolute deviation

-

2,000

3

Net operating profit / loss growth index

-

106.7%

4

Net operating profit / loss growth rate

-

6.7%

5

Interest

1,500

4,500

6

Interest absolute deviation

-

3,000

7

Interest growth index

-

300.0%

8

Interest growth rate

-

200.0%

9

Times interest earned ratio

2000%

711%

10

Times interest earned ratio growth index

-

35.6%

 

 

 

image009

 

Nr.crt.

Solvency

Year 1

Year 2

1

Net profit / loss

25,000

23,000

2

Depreciation

5,000

20,000

3

Earnings before depreciation

30,000

43,000

4

Dividends

10,000

15,000

5

Self - financement

20,000

28,000

6

Self - financement absolute deviation

-

8,000

7

Self - financement growth index

-

140.0%

8

Self - financement growth rate

-

40.0%

9

Long - term loans principal payements

5,000

15,000

10

Long - term loans interest payements

1,500

4,500

11

Debt service

6,500

19,500

12

Debt service absolute deviation

-

13,000

13

Debt service growth index

-

300.0%

14

Debt service growth rate

-

200.0%

15

Debt service coverage ratio

330.8%

166.7%

16

Debt service coverage ratio growth index

-

50.4%

 

image011

 

2.      Evaluation of the liquidity and solvency of the company for year 1

The current ratio for year 1 is of 3.25. Statistically speaking, the level of the current ratio should be between 1 and 2. The value of 3.25 does not show that the company will be able to pay its short-term debt for sure, but it suggests that there are small chances of the company not being able to pay. On the other hand, a large value of the ratio shows signs of poor financial management. With the value of the ratio being significantly over 2, one can conclude that the risks of the company not being able to pay its short-term debt are low, but the risks are being kept at a low level by accepting a lack of efficiency in the management of the financing sources.

The quick ratio shows a similar picture as the current ratio. The optimum level for the quick ratio is considered to be within the interval [0.6, 1). The high value of the quick ratio shows low risks of the company not being able to pay its short-term debt, as the existing cash and receivables turning into cash in less than one year are enough to cover 2.63 times the liabilities that must be paid in cash in less than 1 year. On the other hand, it also shows that the copany holds too much of its capital as cash and receivables. Basically, from the financing point of vue, more than half of the cash and receivables from the first year are being financed through long – term capital. This suggests that either the levels of cash and receivables are too high, or the level of the short-term debt is too low (the company uses too much long – term capital for financing its assets, with the long – term capital being more expensive than the short-term debt).

The spot ratio shows that all short-term debt is held as cash, together with an important part of the long – term capital. With the level of this ratio being over 1, it can be said for sure that the company is able to pay in cash its short-term debt, but the lack of efficiency in the management of the financing sources is equally obvious. The optimum interval for this ratio is considered to be [0.2, 0.6).

The solvency ratio shows that the market value of all assets covers 378% the value of total debt. The ratio is used for judging the payment capacity of the company in the event of bankruptcy. While the liquidity ratios make sense in the hypothesis of the continuation of the activity, the solvency ratio has in vue the scenario of all operation processes being halted.

The minimum value of the ratio to be accepted is of 133%. The assets are valuated in the financial balance sheet at market value – the estimated price to be offerd by the potential buyers under market conditions. Still, in the event of total liquidation, the prices that are estimated to be obtained for the assets are signifficantly lower than market prices.

This means that by covering out of the market value of total assets only 100% of the total debt, the value of the assets in case of total liquidation will not be enough to cover the debt. In addition, the liquidation process generates expenses that are to be covered also.

The times interest earned ratio for the first year has a value of 2000%, which means that the interest can be paid 20 times over of the operating profits. Being able to support the interest payments (which are financial expenses) of the operating profit is essential, as the loans that generate the interest expenses are normally injected into the operating activity. The company cannot be expected to pay the interest of financial revenues, so a ratio lower than 100% is not to be accepted.

Still, the main objectives of the company are not to pay interest, but to use the loans to finance its assets and to manage the assets to generate profits. Being able to pay the interest of the operating profits is important, but, it this case, being able to pay the interest so easy is a consequence of the company not using enough leverage (the debt ratio is of only 26.5%).

The debt service coverage ratio shows whether the company can make the principal payments and the interest payments for long – term loans of the self – financement. A level of at least 100% is required.

The value of the ratio (330.8%) shows that the company should have no problems paying the debt service of the self financement for year 1. Still, a value greater than 100% does not guarantee the payment capacity (the profits may not be cashed in time to make the payments). On the other hand, the company may pay even if the ratio is lower than 100% (by using cash existent at the beginning of the period, by selling fixed assets or by injecting capital from outside sources).

 

3.      Evaluation of the liquidity and solvency of the company for year 2

All liquidity ratios are for the second year below their lower accepted limits. This does not mean that the company is not able to pay the currents bebts, or that it will go banckrupt. It only shows that the risks of the company not being able to pay the currents debts on time are high, with the efficiency of the financing sources management being high as well. Statistically speaking, the combination of risks / efficiency is disproportioned, with the risks being to high to justify the extra efficiency.

The solvency ratio shows that the company will probably be able to pay its debts by liquidating the assets in case of business failure. The times interest earned ratio suggests that the company can afford to pay the interest from the operating profits, as the debt service coverage ratio shows that the company can cover the debt service for long – term loans of the self financement.

4.      Dinamics of the liquidity and solvency ratios

From one year to the other, all liquidity and solvency ratios decrease, reflecting an increasing level of risk of the company not being able to pay both in case of continuing its activity or in case of business failure.

5.      Causes of the dinamics of the liquidity and solvency ratios

The solvency ratio decreases as the growth index of total assets is lower than the growth index of the liabilities. The growth index of the assets is lower than 100% (the value of the total assets decreases) mainly because of the company’s decision to pay dividends at the beginning of the second year (which reduces both the equity and the cash and cash equivalents). There is also an increase in the value of the tangible assets, as the company makes investments in the second year. As the financing sources decrease through the distribution of dividends, the company is forced to ask for a new long – term bank loan (to make the investment in tangible assets).

As the bank loan is not enough to cover the investment, the company makes efforts to reduce the financing sources invested into current assets (inventories and receivables). The inventories decrease although the sales increase, which is possible only through a better management of the inventories (and thus of the financing sources, which are being kept for a smaller period of time as inventories).

The receivables decrease as well, with the sales increasing, which is only possible by reducing the average collection period.

The liabilities increase through the new bank loan (which affects both financial long – term debt and financial short – term debt), as well as through an increase of the accounts payables.

The growth index of the accounts payables is higher than the growth index of the sales, which shows that the average payment period is increasing.

 

6.      Improvement solutions for year 3

With the level of the liquidity ratios being too low for the second year, the management of the company should try to increase current assets at a higher growth index compared to the current liabilities. This will be posible through the increase of long – term capital (as for year 2, the long – term capital is not enough to finance the fixed assets), through the sale of a part of the fixed assets, or through converting current debt into long-term capital.

The solvency ratios do not necessarily need intervention for the 3rd year.

 

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