Discuss measures of long-term liquidity risk

Answer 1

MEASURES OF LONG-TERM LIQUIDITY RISK

Analysts use measures of long-term liquidity risk to evaluate a firm's ability to meet interest and principal payments on long-term debt and similar obligations as they come due. If a firm cannot make the payments on time, it becomes insolvent and may have to reorganize or liquidate.

A firm's ability to generate net income over several years provides the best protection against long-term liquidity risk. If a firm is profitable, it will either generate sufficient cash from operations or obtain needed financing from creditors and owners. The measures of profitability discussed previously therefore apply for this purpose as well. Analysts measure long-term liquidity risk with debt ratios, the cash flow from operations to total liabilities ratio, and the interest coverage ratio.

Debt Ratios

Several variations in debt ratios commonly appear in financial periodicals and corporate reports. We use three debt ratios in assessing long-term liquidity risk:

1 . Liabilities to Assets Ratio = Total Liabilities/Total Assets

2 . Long-Term Debt Ratio = Long-Term Debt/Total Assets

3 . Debt-Equity Ratio = Long-Term Debt/Shareholders' Equity

The liabilities to assets ratio measures the proportion of assets financed with liabilities. The long-term debt ratio measures the proportion of assets financed with long-term debt. The debt-equity ratio measures the extent of long-term financing obtained from long-term debt relative to shareholders' equity.

Because various versions of debt ratios correlate highly, analysts can generally rely on just a couple of these ratios when assessing long-term liquidity risk.

In general, the higher the debt ratios, the higher the likelihood that the firm will be unable to meet fixed interest and principal payments in the future. Most firms must decide how much financial leverage, with its attendant risk, they can afford. Funds obtained from issuing bonds
or borrowing from a bank have a relatively low interest cost but require fixed, periodic payments that increase the likelihood of insolvency or even bankruptcy.

In assessing the debt ratios, analysts customarily vary the standard in relation to the stability of the firm's earnings and cash flows from operations. The more stable the earnings and cash flows, the higher is the debt ratio they deem acceptable or safe. Public utilities have high liabilities to assets ratios, frequently on the order of 60% to 70%. Banks have even higher liabilities to assets ratios, typically over 90%. The stability of earnings and cash flows of firms in these industries makes these ratios acceptable to many investors. These investors might find such high leverage unacceptable for firms with less stable earnings and cash flows, such as a computer software developer or a biotech firm.

Because several variations of the debt ratio appear in corporate annual reports, the analyst should take care when comparing debt ratios among firms.

Cash Flow from Operations to Total Liabilities Ratio

The debt ratios do not consider the availability of liquid assets to service various levels of debt (that is, to provide for interest and principal payments when due). The cash flow from operations to total liabilities ratio overcomes this deficiency. This cash flow ratio resembles the one for assessing short-term liquidity risk, but here the denominator includes all liabilities (both current and noncurrent). A mature, financially healthy company typically has a cash flow from operations to total liabilities ratio of 20% or more.