FIN%204260%20Chapter%202%20Problems_Solutions

FIN%204260%20Chapter%202%20Problems_Solutions - Chapter 2...

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Unformatted text preview: Chapter 2 Analysis of Solvency, Liquidity, and Financial Flexibility Contents Solvency Measures What is Liquidity? Statement of Cash Flows Liquidity Measures How Much Liquidity is Enough? Financial Flexibility Page 8 Chapter 2- Page 9 Answers to Questions: 1. Solvency exists when the value of a firm's assets exceeds the value of its liabilities. Liquidity is impacted by the time an asset takes to be converted into cash and at what cost. TEACHING NOTE: It may be helpful to observe the difference between "book value" solvency based on historical values reflected in accounting systems and "market value" solvency reflecing a combination of mark-to- market values and opportunity costs. 2. Liquidity may also be viewed as the ability of the firm to augment its future cash flows to cover any unforeseen needs or to take advantage of any unforeseen opportunities. This concept of liquidity is referred to as financial flexibility. 3. Sustainable growth rate refers to the growth in sales that can occur given a target profit margin, asset turnover, dividend policy, and debt ratio, such that the firm is not forced to issue new common stock. Thus the sustainable growth is that growth rate at which the firm can grow without raising additional external capital or having to change financial policies. 4. By comparing the balance sheet stock account, such as accounts receivable, to a related income statement flow variable, such as sales which results in a turnover ratio. 5. Lambda includes information about the volatility of expected cash flows. Thus lambda allows the analyst to assess the probability of running out of cash. 6. Perhaps the most important and useful piece of information is the dollar amount of cash provided or used by the firm's operating activities. 7. A current ratio of 2.00 indicates that the firm has $2.00 of current assets for each dollar of current liabilities. A current liquidity index of 2.00 indicates that the firm has $2.00 of cash resources available through cash flow and cash balances to cover each dollar of currently maturing debt. Liquidity focuses more on the ability to actually pay obligations from on-going operations while solvency is more general and is focused more on the coverage relationship between assets and liabilities. 8. Because it is focused on the conversion of asset and liability accounts into cash flow rather than just just being concerned about the relative sizes of the stocks of these accounts. 9. These two measures have a coverage component similar to the current ratio but they also have a time or flow dimension as a result of including a measure of cash flow which relates to the concept of liquidity. Chapter 2- Page 10 10. A firm can have a high current ratio, for example, by having a large balance of uncollectible receivables and obsolete inventory that is financed by long-term funds. Liquidity measures would then be relatively low if these assets are not funds....
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This note was uploaded on 01/24/2012 for the course FIN 4260 taught by Professor Victorwakeling during the Spring '12 term at Kennesaw.

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FIN%204260%20Chapter%202%20Problems_Solutions - Chapter 2...

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