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Chapter 2: FINANCIAL POSITION ANALYSIS

2.1. Financial Balance Sheet

Financial analysis is based both on patrimonial concept of the enterprise as well as on different
classification criteria of balance sheet elements. This approach regards an enterprise as an economic
and juridical entity that owns a patrimony that consists of assets (long-lived and current) as well as
liabilities and equity. The simplest version of an enterprise value is given by its net worth calculated
by subtracting liabilities (to external creditors, both operational as well as financial) from the value
of its total assets (free of all fictive elements).

Financially speaking, each asset element represents an allocation of funds in order to establish a
value creating a structure adequate to the industry and objectives of the enterprise. The simplest
definition of its assets is: the enterprise patrimony components capable of generating future benefits
to its owner. Liabilities and equity reflect the origin sources of funds that assets are formed upon.

Unlike the accounting balance sheet that has a vertical form, the financial balance sheet is based
upon the horizontal concept, all the assets being placed in the right pane, whereas the liabilities and
equity are placed in the left pane.

The order of assets and funds (equity and liabilities) is based upon liquidity-chargeability criteria.
The assets are listed in terms of their increasing liquidity (the assets’ feature of transforming into
cash), whereas the funds – in terms of their increasing chargeability (the funds’ feature of becoming
payable at a certain moment in time).

The specificities of the financial balance sheet include the fact that assets, equity and liabilities are
taken into account by their net value. Thus, financial balance sheet represents a realistic inventory
of the company’s patrimony.

The financial balance sheet construction implies going through two stages:
• correction of balance sheet elements;
• regrouping of corrected elements according to their true liquidity and chargeability nature.

A. Corrections

Financial balance sheet construction implies several corrections applied to the elements of
accounting balance sheet:
- intangible assets are taken into account at their net value; this requires the elimination
of all fictive elements they contain; fictive elements include those components that are
not usually included in the calculation of net worth of a company, thus for the
construction of financial balance sheet these are withdrawn from the assets and, as
well, in order to keep the equality of the balance sheet, the appropriate values are
subtracted from equity; as fictive elements are considered constitution and
development expenses;
- fixed assets are taken into account at their net value; in order to respect the principle of
realistic representation of balance sheet elements, fixed assets should be reevaluated,
thus their value is modified compared to the value from accounting balance sheet; the
difference is also summed up to the value of equity; considering that usually, in
Romania, assets reevaluation happens once in five years (from taxation reasons), and a
reevaluation as a time consuming and expensive endeavor, usually the analyst will

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consider the accounting value as the real value of the assets to be taken into account in
the financial balance sheet;
- prepaid expenses are also considered fictive assets and will be eliminated, the value
being also subtracted from equity;
- equity is diminished by the value of capital subscripted but not paid by shareholders,
subsequently reducing the value of accounts receivable from shareholders.

B. Regrouping corrected elements

This stage of financial balance sheet construction focuses on obtaining groups of homogeneous
elements in terms of liquidity in the asset pane and in terms of chargeability in the capital pane:
- for assets: long term assets (with a period of liquidity over a year) and current asset
(with a period of liquidity less than a year);
- for liabilities: long term capital (with a period of chargeability over a year, both own
and external) and short term liabilities (with a period of chargeability less than a year).

For this purpose the following operations will be carried out:


- long term financial investments will be separated based upon their real liquidity period
and will be either left in long term assets component (those with a liquidity period over
a year) or inserted in current assets (those with a liquidity period less than a year);
- slow turnover or unsalable inventories will be inserted into fixed asset group, the rest
being left in current assets component;
- accounts receivable will be classified by the term of the liquidity: the component that
will be collected in less than a year will be held within the current assets, the rest will
being moved to long term assets;
- short term financial investments that will be cashed in less than a year will be kept in
short term assets, whereas those with a liquidity more than a year away will be moved
to long term financial investments;
- the component of long term debt payable in less the 12 months will be moved to
current debt;
- short term liabilities that have a chargeability period of more than a year will be moved
to long term liabilities;
- provisions are considered as elements deducted from current revenues in order to
constitute reserves for any future risks or uncertain expenses; in the case they are
legitimate, they will be moved either to long term liabilities or to short term liabilities,
depending on their maturity; if they are not legitimate, will be considered as equity;
- advance revenues will also be assimilated as equity.

Financial Balance Sheet – changes to accounting balance sheet


(corrections and regrouping)

ASSETS EQUITY AND LIABILITIES


I. Long term assets: I. Equity
1.1. Intangible assets – constitutive expenses
– constitutive expenses – development expenses
– development expenses +/– reevaluation differences
1.2. Fixed assets – receivables from shareholders
+/– reevaluation differences – prepaid expenses
+ slow turnover or unsalable inventories + non-legitimate provisions
+ advance revenues

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ASSETS EQUITY AND LIABILITIES
II. Long term liabilities:
1.3. Long term financial investments 2.1. Long term loans
– long term financial investments (liquidity < – long term loans with payment < 1 year
1 year) + short term loans with payment > 1 year
+ accounts receivable (liquidity > 1 year) 2.2. Operational long term liabilities
+ short term financial investments (liquidity > + legitimate long term provisions
1 year) + short term liabilities with payment > 1 year

II. Current assets: III. Short term liabilities:


2.1. Inventories 3.1. Operational liabilities:
– slow turnover or unsalable inventories 3.1.1. Suppliers accounts payable
2.2. Accounts receivable – liabilities with payment > 1 year
– receivables from shareholders 3.1.2. Other short term operational liabilities
– accounts receivable (liquidity > 1 year) + legitimate short term provisions
2.3. Cash and short term financial investments: + long term liabilities with payment < 1 year
2.3.1. Cash at bank and in hand – short term liabilities with payment > 1 year
2.3.2. Short term financial investments 3.2. Short term financial debts
+ long term financial investments (< 1 year) + long term loans with payment < 1 year
– short term financial investment (> 1 year) – short term loans with payment > 1 year
Total Assets Total Capital

Finally, financial balance sheet has the following structure:

Financial Balance Sheet

ASSETS EQUITY AND LIABILITIES


I. Long term assets: I. Long term capital
1.1. Intangible assets 1.1. Equity
1.2. Fixed assets 1.2. Long term liabilities:
1.3. Long term financial investments 1.2.1. Long term loans
1.2.2. Operational long term liabilities
II. Current assets: II. Short term liabilities:
2.1. Inventories 3.1. Operational liabilities:
2.2. Accounts receivable 3.1.1. Suppliers accounts payable
2.3. Cash and short term financial (Commercial debts)
investments: 3.1.2. Other short term operational liabilities
2.3.1. Cash at bank and in hand 3.2. Short term financial debts
2.3.2. Short term financial investments
Total Assets Total Capital

2.2. Asset structure analysis

Structure analysis aims to reflect the relationship between different balance sheet elements and
changes that take place in a company’s capital and its allocation. This type of analysis is called a
vertical analysis because it tackles separately assets as well as liabilities and the manner in which
each of these is structured.

Factors that affect the balance sheet structure are:


• Economic and technical factors:
- intensity of capitalization;
- the duration of enterprise’s operational cycle;
• Juridical factors:
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- Current business rules and regulations;
• Conjectural factors;
• Strategic options of the enterprise;
• Size of the enterprise.

Structure ratios are calculated as a ratio between an asset or liabilities element (or group of
elements) and total assets or liabilities, as well as an asset or liabilities element and the total amount
of the group it is part of.

The assets structure analysis emphasizes the following:


- the economic destination of the invested capital;
- the liquidity of the invested capital;
- the ability of the enterprise to modify its assets structure under the influence of external
(market or industry) factors.

The most important asset structure ratios are:

1) Long-term assets ratio (RLTA)

This ratio measures the degree of investment of company’s capital and is calculated as a ratio
between long term assets (LTA) and the total assets (A). The long-term asset ratio is assessed
according to company’s industry. For a manufacturing company, the values of this ratio that
indicate a normal situation are situated around the 60% level.
Long term assets
R LTA = × 100
Assets
In order to further advance the analysis there could be used some complementary structure ratios for
long-term assets analysis, as shown below:

1.1) Intangible assets ratio (RIn)

Reflects the proportion of intangible assets (In) in either total assets or long-term assets. When
calculated as a ratio to long-term assets, it reflects the relative importance of intangible assets for
company’s activity and operations – the intensity use of research & development (R&D) processes
in generating new products and technologies, or the dependence on certain specific software
systems.
In tan gible assets In tan gible assets
R IN = × 100 R *IN = × 100
Assets Long term assets

1.2) Fixed assets ratio (RFA)

Reflects the proportion held by tangible investments in total non-current assets of the company or in
total assets; moreover, the ratio indicates the potential flexibility of the company in its efforts to
adjust to the changes that affect its markets and used technologies. The higher is the percentage of
fixed assets, the more focused and specialized are the company’s assets as a whole, the lower is the
emphasis on intangible assets (that reflects innovation concern of the company) as well as the
financial long-term assets (that reflect the degree of company’s involvement of the financial
markets or the membership in a holding).
Fixed assets Fixed assets
R FA = × 100 R *FA = ×100
Assets Long term assets
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1.3) Long-term financial investment ratio (RLTFI)

Reflects the financial investment policy of the company and expresses the intensity of its equity
relations with other companies.
Long term financial investments Long term financial investments
R LTFI = × 100 R *LTFI = × 100
Assets Long term assets

There are some validation equations for these ratios:

R In + R FA + R LTFI = R LTA and R*In + R*RA + R*LTFI = 100%

2) Current assets ratio (RCA)

Current assets ratio expresses in relative terms the amount of capital invested in company’s
operations. Due to the fact that this amount of capital is renewed with each operating cycle, it is also
called circulating capital. As well, this ratio measures the liquidity degree of a company’s assets. Its
value depends greatly upon the industry the company runs in, but a value of 40% is considered
convenient for a manufacturing company.
Current assets
R CA = × 100
Assets

The long-term and current assets ratios should meet the following principle:

RLTA + RCA = 100%

As in case of long-term assets, current assets structure could be broken down into complementary
ratios.

2.1) Inventory ratio (RInv)


Inventories Inventories
R Inv = × 100 R *Inv = ×100
Assets Current assets

The level of this rate depends upon many factors, for instance:
- the enterprise’s industry or industries;
- duration of enterprise’s operational cycle;
- market price fluctuations.
An increase of inventory proportion is justified when it comes as a result of turnover growth,
whereas it is considered improper if it results in buildup of slow moving or unsalable inventories.

A closer look on the inventory structure, in case of a manufacturing enterprise, requires the analysis
of other three complementary ratios: ratio of raw materials, ratio of wok-in-progress inventories and
ratio of finished goods. In case one of the three elements is prevalent in the inventory structure it
can indicate industry or enterprise specific inventory management situations. As well, exaggerated
levels of some inventory components can indicate poor inventory management situations. For
instance, an oversized raw material inventory can either signify a prudential supply management
policy, but as well it can indicate problems in value and structure of raw material inventory
management, which lead to accumulation of slow moving or unusable inventories.

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If an enterprise carries out only trade operations, than the sole structure ratio which is useful for
analysis is merchandise inventory ratio.

2.2) Accounts receivable ratio (RAR)


Accounts receivables Accounts receivables
R AR = × 100 R *AR = ×100
Assets Cuurent assets

This ratio is greatly influenced by the company’s industry, the nature of business relations with its
partners and as well by the average period outstanding for the payment of deliveries by the
company’s clients. This ratio is quite small or nil if the company sells its products or services for
cash to individual clients (retail, some services rendered directly to the consumers) and has large
values when the company has as clients other companies.

2.3) Cash and cash equivalent ratio (Rcash)

Cash Cash
R cash = ×100 R *cash = × 100
Assets Current assets

The ratio expresses the proportion of cash (cash at bank and in hand) and cash equivalent (short
term financial investments) in total assets or current assets. A high level of this ratio means cash
might not be used in an efficient way especially if it results in a large amount of money in bank
accounts. A low level might lead to difficulties in covering short term debts.

The ratio can be split into two ratios.

2.3.1) Short-term financial investment ratio (RSTFI)

Short term financial investements Short term financial investements


R STFI = ×100 R *STFI = × 100
Assets Current assets

The level of this ratio depends upon two cumulative factors: the operational activity of the
enterprise generates cash flows available for long periods of time due to certain reasons (profitable
operations, seasonal variations of cash-flows etc.) as well as risk acceptance from the management
team that makes possible the placement of cash flows on the financial market using different
available instruments (shares, bonds, futures etc.).

2.3.2) Cash at bank and in hand ratio (RCBH)

Cash at bank and in hand Cash at bank and in hand


R CBH = × 100 R *CBH = × 100
Assets Current assets

A high cash ratio can indicate a favorable situation of an enterprise in terms of financial balance,
but it can as well be a sign of inefficiently used resources. Moreover, the level of cash can fluctuate
greatly over short periods of time, so that it can rise steeply when important amounts of cash are
incurred from clients or it can decrease swiftly due to important payments made to suppliers or
other partners. The normal level of this ratio is about 5% to 10% compared to total assets. In the
long run, the existence of a large amount of cash at bank or in hand signifies as well a risk aversion
management attitude, that do not accept placement of free cash using alternative risky but, at the
same time, more profitable options.

There are some validation equations for these ratios:


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R Inv + R AR + R cash = R CA and R*Inv + R*AR + R*cash = 100% .

2.3. Financial structure analysis

The financial structure ratios highlight the way the capital is structured in terms of its provenance
and its degree or chargeability. Financial structure analysis aims to assess main financial strategies
and policies regarding formation of financial resources in terms of their origin (own, borrowed or
attracted from operational creditors) and in terms of their chargeability (short term and long term).

The capital a company uses can be classifies according to several criteria.

a. Chargeability (maturity):
- long term capital: equity and long term liabilities;
- short term liabilities.

b. Ownership:
- equity;
- liabilities (debts).

c. According to their nature, liabilities can be:


- operational liabilities;
- financial liabilities (loans).

2.3.1. Financial structure analysis according to chargeability

1) Financial stability ratio (RFS)

This ratio reflects the proportion of long-term capital in total capital. Long-term capital comprises
both equity and long-term liabilities.

Long term capital


RFS = × 100
Capital

Financial stability of an enterprise is as high as the value of this ratio closes to 100%. The minimal
accepted value for a manufacturing company is 50%, while normal value being around 67%.

Dynamically, the ratio should have an increasing trend, an effect of enterprise’s profit generating
activity, increases in shareholders’ equity and attraction of new long-term bank loans.

2) Short term liabilities ratio (RSTL)

This ratio reflects the proportion of short term liabilities in total capital.
Short term liabilities
RSTL = × 100
Capital

For a manufacturing company, the maximum value of this ratio is 50%, while the normal value is
around 33%.

Validation equation:

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R FS + R STL = 100% .

2.3.2. Financial structure analysis according to ownership

1) Financial autonomy ratio

Financial autonomy highlights the extent to which financial sources of an enterprise belong to its
shareholders (owners). The greater is the proportion of equity in total capital – the larger is the
company’s independence from external lenders.

There are two types of financial autonomy:


- Global financial autonomy, when equity is compared to total capital;
- Long-term financial autonomy, when equity is compared to long-term capital.

1.1) Global financial autonomy ratio (RGFA)

It is calculated as ratio between equity and total capital.

Equity
RGFA = × 100 .
Capital

This ratio is especially important to lending institutions such as banks, when the company request a
new loan.

The minimal accepted value for this ratio is 33%, while normal value being around 50%.

1.2) Long-term financial autonomy ratio (RLTFA)

It is calculated as a ratio between equity and long-term capital.

Equity
RLTFA = × 100 .
Long term capital

It is considered that for a healthy financial structure (a low indebtedness risk) this ratio must have a
value of at least 50%.

2) The debt (indebtedness) ratio

The indebtedness ratios (the leverage ratios) express in percentage measures the level of a company
debts compared to either its total capital or long-term capital.

Business environment uses two main indebtedness ratios:


- Global indebtedness ratio;
- Long-term debt ratio.

2.1) Global indebtedness ratio (RGD)

This ratio compares total debts (D) that a company has accrued in its balance sheet with total
capital.

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Debts
RGD = × 100 .
Capital

The maximal level of global indebtedness, that indicates an acceptable risk level, is around 67%.
Dynamically, the ratio should have a downward trend, as an effect of debt growing slower that total
capital, the most favorable situation being that of long-term debt reimbursement by the company as
well as the reduction of short-term debt.

RGFA + RGD = 100%.

2.2) Long-term debt ratio (RLTD)

This ratio compares long-term debt (usually comprised of bank loans) with long-term capital.

Long term debt


RLTD = × 100 .
Long term capital

If the value of this ratio exceeds 50%, the enterprise is in danger of insolvency. The possibilities of
getting approved new bank loans are as high as this ratio is low.

RLTFA + RLTD = 100%.

2.4. Static financial balance analysis

Out of many available definitions of financial balance we will retain the one that expresses it as the
equality between financial sources and financial requirements of the operational processes carried
out in an enterprise, short term and long term alike.

Financial balance analysis can be approached in two different ways, namely:


- a static approach – financial balance indicators are calculated based upon information from
financial balance sheet and reflect a static image (at a certain moment) of the manner
financial balance is reached;
- a dynamic approach – financial balance of the enterprise is referred to in terms of cash-
flows, so that it analyses the extent to which incoming cash flows cover outgoing ones
(payments) over a period of time.

The two basic equations of a financial balance are:

Long-terms assets = Long-term capital


Current assets = Current liabilities.

Static financial balance analysis is done with the help of the following indicators:
- Working capital, working capital requirement and treasury;
- Liquidity and solvency.

2.4.1. Working capital, working capital requirement and treasury

The three specialized indicators cover a certain segment of financial balance in terms of time extent:
- working capital (floating capital): long-term financial balance analysis;
- working capital requirement: short-term financial balance analysis;
- treasury: global financial balance analysis.
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A. Working capital (WC)

Working capital (also known as net working capital) represents the amount of long-term capital that
is used to fund current assets.

When long-term capital is in excess of long-term assets, one could say that an enterprise have a
working capital that can be used (rolled over) to renew some components of the current assets. Thus
working capital plays the role of a financial safety margin that allows a company to meet its
operational requirements whenever current liabilities do not stand up to the challenge.

WC is calculated in two different ways:

a) based upon the upper part of the balance sheet, as a difference between long-term capital
(LTC) and long-term assets (LTA):

WC = LTC – LTA

Long-Term Assets
Long-Term Capital
Working Capital

b) based upon the lower part of the balance sheet, as a difference between current assets
(inventory + accounts receivable + cash & cash equivalents) and current liabilities (CL)
(operational liabilities + short term financial liabilities):

WC = Current assets – Current liabilities

Current liabilities
Current assets
Working Capital

Cash includes cash at bank and in hand, while cash equivalents include short term financial
investments.

Each of the two methods used to calculate working capital highlights a certain specific but
nevertheless complementary aspect regarding this indicator:
 establishment of working capital based upon the upper part of the balance sheet reflects
the manner in which firm’s financial structure affect the process of operational financial
sources build up;
 establishment of working capital based upon the lower part of the balance sheet reflects
in real terms the future liquidity of the enterprise, playing the role of a potential
liquidities excess that is used as a safety net in the operational activity and can lower
operational risks that affect the company.

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If current assets are less than current liabilities, an entity has a working capital deficiency, also
called a working capital deficit.

A company can be endowed with assets and profitability but short of liquidity if its assets cannot
readily be converted into cash. Companies with huge assets have still collapsed because they could
not generate enough cash to sustain the business and pay short term debts. Positive working capital
is therefore required to ensure that a firm is able to continue its operations and that it has sufficient
funds to satisfy both short-term debts and upcoming operational expenses (salaries, equipment
rental, inventory, and so on). The management of working capital involves managing inventories,
accounts receivable and payable, and cash.

A negative working capital (more immediate liabilities than cash assets can be a bad signal to
investors. This figure indicates that creditors cannot be paid and the firm could go bankrupt in the
near future. It might also suggest that the sales volume is gradually decreasing, resulting in
shrinking accounts receivable, or that the excessive inventory requires too much money.

B. Working capital requirement (WCR)

Working capital requirement represents the part of current assets (excluding cash) that should be
covered from long-term capital (from working capital, more accurately).

Normally, current assets (inventory and accounts receivable) should be covered from operating
liabilities. In case there aren’t sufficient, long-term capital is used to cover the difference. WCR
reflects the amount of inventory and accounts receivable which are not funded by operating
liabilities.

WCR = (Inventory + Accounts receivable) – Operating liabilities

WCR may be both positive and negative:


• WCR > 0: the operating liabilities no longer cover the short-term assets.
• WCR < 0: the firm attracted commercial debts large enough to cover short-term assets.

A positive WCR means the company needs additional resources (other than operating liabilities,
which are not sufficient) in order to completely cover inventory and accounts receivable. The
capital used in this respect is the WC (if positive). But in the eventuality that WC is not sufficient as
well to cover the difference, bank loans are to be used.

Inventory and accounts receivable can be there covered by the following resources:
- operating liabilities;
- working capital (long term capital);
- bank loans.

Each of these resources is being used if the previous resource(s) is (are) not sufficient to cover the
current assets.

A negative WCR means the operating liabilities fund a part of the long lived assets. Despite
commercial debts require no interest to be paid a great level of them could increase the financial
dependence of the company on its suppliers. This further leads to higher financial risks for the firm.
That’s why it is advisable to reduce working capital needs in the future.

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Both the working capital and the working capital requirement are different for each company,
depending upon many factors. For this reason, there is no ideal amount of the two figures that is
universally applicable to all businesses, or even to companies engaged in the same industry.

C. Treasury

Treasury (T) or net cash of a company is the image of company cash and cash equivalents,
generated by ongoing evolution of cash collection and payments, respectively of short-term cash
investments.

Treasury can be calculated based on two formulas:


- as a difference between working capital and working capital requirement:

T = WC – WCR

- as a difference between cash and cash equivalents, on one side, and short-term financial
liabilities, on the other hand:

T = (Cash + Cash equivalents) - Short-term financial liabilities.

The treasury analysis covers two possible situations:

a) T > 0; WC > WCR

If treasury has a positive value, then the excess of funding sources over needs will take the form of
cash at bank and in hand.

This is a convenient case for an enterprise; it has a short-term financial independence and overall
financial balance.

Not always a positive value of treasury is a sign of an efficient company, because long-term cash
abundance could highlight an insufficient use of those cash resources.

b) T < 0; WC < WCR

A negative treasury indicates a global financial misbalance, a cash deficit that is covered by short-
term bank loans.

Such a situation shows out a dependence of company’s operations on external short-term financial
sources which tend to be more expensive, especially when funding gap is acute. The company
dependence on external capital limits its financial independence in the short-run.

A negative treasury could be favorable to a company only if the cost of short-term external funding
is inferior to operational returns, meanwhile the period for which the company uses short-term bank
loans is carefully calculated so that it does not stay dependent on external funding when this
situation changes.

2.4.2. Liquidity and solvency

Liquidity and solvency analysis reflects enterprise’s ability to repay its debts, comprised both of
short-term and long-term liabilities. Meanwhile, liquidity and solvency belong to measures used to
assess the company’s financial balance. Liquidity and solvency analysis highlights a certain
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financial condition of the enterprise in terms of its ability to repay its debts with different
chargeability terms.

Liquidity refers to the company’s ability to sell short term assets quickly to raise cash in order to
pay its short-term obligations. A firm with adequate liquidity has enough cash available to pay its
bills.

Solvency regards the company's capacity to repay its long-term debts. A solvent company owns
more than it owes. It has a positive net worth and a manageable debt.

Solvency and liquidity are equally important for the financial health of the firm. Healthy companies
are both solvent and possess adequate liquidity.

Both measures are approached by financial statement analysis using ratio method. A number of
financial ratios are used to measure a company’s liquidity and solvency, the most common of which
are discussed below.

A. Liquidity ratios

A.1) Current ratio measures the firm’s ability to pay off its current liabilities (due within one year)
using its current assets (inventory, accounts receivable, cash and cash equivalents). It is calculated
as a ratio between current assets and current liabilities:

Current assets
Current ratio =
Current liabilities

Generally, the higher the current ratio, the more liquid the firm is considered to be.

A current ratio of 2 is occasionally cited as accepted, but a value’s acceptability depends on the
industry in which the firm operates. For example, a current ratio of 1 would be considered
acceptable for a public utility company but might be unacceptable for a manufacturing firm. The
more predictable a firm’s cash flows, the lower the acceptable current ratio.

The generally acceptable values of the current ratio are:


 the minimum value is 1, and a ratio bellow this threshold usually indicate an insufficient
current liquidity;
 the maximal value is 2, a ratio that exceeds this value indicating an inefficient use of firm’s
current assets.

A.2) Quick ratio is similar to the current ratio except that it excludes inventory, which is generally
the least liquid current asset. Quick ratio measures the firm’s ability to meet its short-term
obligations with its most liquid assets. It is also known as the “acid-test ratio.”

Current assets - Inventories


Quick ratio =
Current liabilities

The generally low liquidity of inventory results from two primary factors:
- many types of inventory cannot be easily sold because they are partially completed items or
special-purpose items;
- most of the times goods are sold on credit, which means that inventory becomes an account
receivable before being converted into cash.

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The acceptable values of this ratio are:
- the minimum value is 0,8, and a ratio lower than this indicate an insufficient firm’s quick
liquidity;
- the maximal value is 1,0, a ratio that exceeds this value indicating an inefficient use of
firm’s liquid assets.

Liquidity ratio analysis is usually carried out using financial balance sheet data. This data reflects
the assets and liabilities at a certain moment in time, usually on 31st of December of the year used
in the analysis. Thus, an assessment of liquidity is made for the whole year using the balance sheet
information reflecting a single day of that year. The asset components of the balance sheet,
especially the most liquid ones (such as cash, accounts receivable etc.), as well as a part of current
liabilities have quite a volatile nature, as in having large variations over short intervals of time.
Consequently, the value of certain current asset and current liability elements might not be relevant
for the entire year. In such a case, interpretations and conclusions could be distorted by this
unrepresentative nature of financial data, so that firm’s liquidity will be judged based upon values
either too big or too small in comparison with the company’s real financial position.

B. Solvency ratios

B.1) Assets to debts ratio (RA/D) reflects the firm’s ability to satisfy its overall debt using the total
assets.

A ssets
R A/D =
Debts

This ratio measures the amount of assets that have to be sold in order to repay the debt (short-term
and long-term). It is considered that total assets represent a guarantee for exceptional situation, as
bankruptcy, in which coverage of debts is accomplished selling all of the company’s assets. A
higher ratio indicates a greater coverage of debt and therefore a lower risk.

The minimal acceptable value of this ratio is considered to be 1.5; a normal value for this ratio is 2
or higher.

B.2) Interest coverage ratio reflects the degree the operating result covers the interest expense. The
ratio is calculated as follows:

Operating result
Interest coverage ratio =
Interest expense

This ratio measures the company’s ability to meet the interest expense on its financial liabilities
with its operating result (if positive). The higher the ratio, the better the company’s ability to cover
its interest expense.

The minimal acceptable value is 1, which means that the company is capable of covering bank loan
interest from operating profit.

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