A Comparative Analysis of The Effectiveness of Three Solvency Management Models

From Cashwiki.org.org, the Money Wiki
Jump to: navigation, search

Liquidity Management and Organizational Efficiency/Effectiveness

The measurement of organizational efficiency underscores in real terms the viability and feasibility expectancy of any organization. How effective an organization becomes is a matter of how competent the overall management is. Efficiency is a function of effectiveness but the two are jointly used to appraise the consequential outcome of the operational activities of an organization which in turn determines the feasibility expectancy of that organization. Efficiency is less precise and definite than effectiveness in that it denotes the relationship existing between inputs and resultant outputs (Anyigbo 2004). In a comparative analysis of corporate efficiency, Kax and Kahn (1987) in Anyigbo (2004) states that more efficient organizations produce more outputs, for the same amount of given inputs; and, therefore, performs financially better. Usually, the going concern ability of an organization is greatly anchored on the continued solvency of that organization, while solvency in turn is determined by the continued viability of the firm; and viability of any organizations is (most certainly) a function of the organizational efficiency.

Working Capital Management

The real management of organizational solvency is vested in the efficient manipulation of the components that makeup the organization’s working capital base. To begin with, “working capital is a margin or buffer for meeting obligations within the ordinary operating cycle of the business” AARB NO. 43 in Osisioma (1997). In other words, working capital represents the circulating capital of an organization and it may comprise:
_ Stocks of trading goods, raw materials, work-in-process and stationeries.
_ Debtors and other receivables
_ Bank balances and cash
_ Marketable securities and other short term claims on third parties.
The definition of working capital is however, incomplete without the other side of it; the current liabilities –which include short term claims by third parties on the business. In the true sense of it, working capital is the net difference between the organization’s current assets and the current liabilities. For there to be efficiency in working capital management, Osisioma (1997) pointed out that there must exist two elements in the working capital quality namely:

  1. Necessary Components; and
  2. Desirable Quantities.

He insists that good working capital management must ensure an acceptable relationship between the different components of a firm’s working capital so as to make for an efficient mix, which will guarantee capital adequacy as well as make available to the management the desirable quantities of each component of the working capital.
The question here is what constitute the necessary components of a firm’s working capital and how much of such necessary components can be regarded as adequate or desirable? The answer to the first part of the question is not farfetched; the necessary components of an organization’s working capital will typically follow the trend in the organization’s type of business or industry. The common components of working capital for most organizations include cash, debtors, receivables, inventories, marketable securities and redeemable futures. The question as to the adequacy of each component is a matter of conjecture based on more stringent measure tailored in accordance with the need, size and scope of the operations of the firm. Insolvency and other unsavoury financial problems occur as a result of the inability of the management to identify this need, size and scope and the corresponding quantity of each component of working capital necessary for them. The branch of management activity saddled with answering this question is the financial management. Financial management refers to a decision making process in the prudent utilization of capital resources of a business enterprise (Okeke, 2000). Financial management can also be defined as the management of business capital resources (Adegeye and Dittoh, 1982 in Ezeagba (2000)). In other words, financial management can equally be said to cover the core subject of management since it is also seen that the main objective of management is equally anchored on the prudent utilization of capital resources in the achievement of an organizational goal. The distinguishing factor however, remains that financial management requires specialization and expertise and may be concerned with mainly advises on the prudent allocation and/or re-allocation of the resources of the organization as converted into financial format. Financial management provides the basis for business planning, investment, diversification and cash flow statements (Okeke, 2000). Thus, it can rightly be said that the objective of financial management in any organization revolves around prudent management / utilization of the capital resources of that organization towards the achievement of its primary goals in business. To achieve this objective, the firm needs to attain high efficiency in its financial management because the major reason for poor performance is usually weak and ineffective financial management.

Metrics of solvency

The introduction of the Altman’s Z-score model in 1983 and much recently the Enyi’s Relative Solvency Ratio model in 2005 has divergently provided financial analysts with alternative methods of analyzing corporate solvency which hitherto was exclusively done using the traditional historical record based ratio analysis, with particular reference to the current ratio.

Ratios

Ratios are figures obtained by comparing actual outcome with an expected outcome usually expressed in decimal fractions, percentages and sometimes real numbers. Ratios are useful for comparative analysis of facts and for feedback. Without adequate/accurate feedback, there will be no control or corrective decision making, hence, plans and objectives may become difficult, if not impossible, to attain. The common ratios usually employed in the management of organizational solvency include:

  1. Current Ratio
  2. Quick /Acid Test Ratio
  3. Debt /Equity Ratio
  4. Debt /Total Assets Ratio
  5. Capital Adequacy Ratio
  6. Liquidity Index

Current Ratio

The current Ratio also known as the working capital ratio measures the totality of all current assets against current liabilities. The current Ratio is a crude measurement of the organizational solvency, as it affects current liabilities’ creditors only. In the opinion of Jafar & Sur (2006:239), it is a basic measure of liquidity. The higher the ratio the more will be the capability of the company to meet its current obligations out of its short-term resources and accordingly, the greater is the margin of safety to short-term creditors. The normal acceptable current ratio is 2:1. This is based on the logic that in the worse situation, even in the event of 50% shrinkage in the value of current assets, the firm will be in a position to pay off its current obligations (Bardia, 2006:225)

Altman’s Bankruptcy Prediction Model

The first attempt to, perhaps, suggest a more effective way of diagnosing corporate insolvency was made in the works of Altman (1983) in which he used the discriminate analysis technique to calculate bankruptcy ratio. This ratio which uses the Z value to represent overall index of corporate fiscal health, is used mostly by stockholders to determine if the company is a good investment. The formula for the ratio is

  Z = 1.2X1 + 1.4X2 + 3.3 X3 + 0.6X4 + 1.0X5

Where

  X1  = Working capital divided by total assets
X2 = Retained earnings divided by total assets
X3 = Earnings before interest and taxes divided by total assets
X4 = Market value of equity divided by the book value of total of total debt.
X5 = Sales divided by total assets.

The range of the Z-value for most corporations is between -4 and +8.
According to Altman (1983), financially strong corporations have Z values above 2.99, while those in serious trouble have Z value below 1.81. Those in the middle are question marks that could go either way. The closer the firm gets to bankruptcy/insolvency, the more accurate the Z value is as a predictor.

A critical look at the components of the Altman’s Z value formula and the interpretations reveal that, though the Z-value ratio is a milestone in the prediction of corporate insolvency, it suffers in precision and is likely to mislead the user unless, and of course, the corporation under analysis has already reached the problem spot. Also, more confusing is the range of acceptable values, users would perhaps, have preferred Z-value set in fractions or percentages as these are more or less universal and better understood than the number range used. Though, Altman rightly included working capital, retained earnings and earnings before interest and taxes in his analysis as these are the main, if not the only, determinants of corporate solvency, the inclusion of such items as market value of share and total sales serves little or no purpose in the determination of the corporate solvency. This is because you can make billions of Dollar of sales and yet record losses; and as posited earlier, it is profits that fuel continued cash flow, losses only dwindle them. In the same vein, the market value of a company’s share is external and has nothing to contribute to either profitability or cash flow. Hence, the inclusion of these two in the analysis only goes further to distort the consequent Z-value outcome.

Business solvency revolves primarily around the working capital base of the organization; the fixed assets are only called upon at the critical but more agonizing stage of dismemberment when the death throes have already set in. The objective of any predictive function is to fore warn about a situation so that it can be avoided or taken advantage of. When this is lacking in a tool, then the tool becomes ineffective. Nevertheless, Altman’s work is still a very useful reference point in the analysis and study of business insolvency.

Enyi’s Relative Solvency Ratio (Solvency Prediction) Model

The quest for a more reliable solvency indication and predictive tool lead to the development of the operational break-even point (OBEP) and its dependant, the relative solvency ratio RSR by Enyi Patrick Enyi as part of a PhD thesis work in the year 2005.

Operational Break-Even Point (OBEP)
One of the cardinal tools introduced with the development of Enyi’s Relative Solvency Ratio model is the operational break-even point (OBEP). The operational breakeven point can be defined as “the point or stage of activity where cumulative contribution margin on recovered production outputs equal the total cumulative production costs and losses of the learning periods” (Enyi, 2005). In other words, it is the point where the firm has made enough profits to cover all attributable costs. At this point, production, marketing, technical, labour and managerial inputs have become normal and are efficiently combined.
The OBEP is measured in number of production or activity cycles. These cycles may be in days, weeks or months but the general and most common assumption as used in this discuss is in weeks.

The idea for developing the operational break-even point was muted from the fact that the successful set up and survival of any business will always depend partly on the entrepreneurial skill of the owners or managers and to a greater extent on the availability of adequate capital. This is because set-up and operational costs seem to be higher when inexperience and incompetence exist; and these costs eat deeper and faster into the available capital and only cease to do so when operations have reached general stabilization point (Enyi, 2005). Where the capital is inadequate, the ultimate result will be early liquidation unless there is a saving grace. Reason being that in the early stages of a business, there will exist some initial learning problems which diminish with time as they are detected and solved. The point of activity where these problems disappear completely is the firm’s stabilization point or operational perfection point. This stabilization point is not the same as the operational break-even point. The stabilization point is usually reached first and earlier than the operational break-even point. Though a low level of capital may get to the stabilization point but to get to the operational break-even point and beyond will depend on the availability of adequate capital as well as the application of a robust mark-up ratio policy. If the initial capital invested is inadequate, the learning problems will deplete it to a point where it will become so weak and unable to keep the business going when stabilization is attained. The formula for the measurement is:
. OBEP = (1+m) / 2m
Where,
. m = mark-up ratio
. OBEP = Operational Break-Even Point

The operational break-even point (OBEP) is expressed in number of production cycles. A production cycle is the time it takes to produce and market a measurable standard of marketable goods and services. A cycle can be in days, months, weeks or quarters (Enyi, 2006).

Mark-up Ratio (MUR)
The mark-up ratio is important in the measurement of operational break-even point. The mark-up ratio, here indicates remotely the competence and ability of the management of a firm in the recovery of costs and consequently in the maximization of profit (Enyi, 2005). A firm’s long-term survival depends on its ability to sell its products at prices that will cover costs as well as provide a profit margin that will ensure a reasonable rate of return to its investors (Glautier & Underdown, 1997). Also Morse & Zimmerman (1997) posited that the pricing decision is one of the most important aspects of a manager’s job because if the price of a firm’s products or services is set too high, no one will buy the product, and insolvency condition sets in. Likewise, if the price is set too low, the firm will generate sales but will not be able to cover all costs and this can also lead to the firm’s failure. The mark-up ratio (MUR) is measured by dividing the profit before tax (PBT) with the total operating cost (TOC). Total operating cost is measured by deducting the profit before tax from the total sales (TS).
. MUR = PBT / TOC
. PBT = TS – TOC
. TOC = TS – PBT

Working Capital Required (WCR) At Operational Break-even Point.
Arriving at the firms’ operational break-even point is one part of the story. The other part lies in estimating the volume of working capital adequate to sustain the operational break-even. It is the opinion of Enyi (2005) that working capital measured using the operational break-even point is a superior measurement of capital adequacy, because it is a working capital estimate relative to the competence and size of the organization’s operations. Besides, it is only possible to predict solvency status using this type of working capital estimate. The formula is:
. WCR = (TOC / 52) * OBEP
Where,
. TOC = Total Operating Cost = TS - PBT
. TS = Total Sales
. PBT = Profit Before Tax

Here, the 52 represents the number of weeks in a year; assuming that all firms stock up for at least one week’s operation. However, 300 and 12 may be used to represent days and months but the study reported in Enyi (2006) shows that weekly usage is more appropriate and gives more accurate result.

Relative Solvency Ratio (RSR)
The relative solvency ratio measures the liquidity of a business by comparing the available working capital with the required working capital. The required working capital as measured above approaches solvency determination in terms of the availability of adequate working capital against the cumulative demands of continuous production and trading inputs. The relative solvency ratio is measured as follows:
. RSR = Available Working Capital / WCR
Where,
. WCR = Working Capital Required at OBEP

The relative solvency ratio can help the organization to determine when external sources of financing working capital are needed and when they are no longer desirable. Recent analysis as in Enyi (2006) has also shown that the relative solvency ratio can be effectively applied in the measurement of bank liquidity for effective bank and financial services administration. Most importantly, the relative solvency ratio can be used to predict the likelihood of insolvency and the possible stage that insolvency is expected to occur. The likelihood of insolvency is measured as:
. COI = 1 – RSR
Where,
. COI = Chance of Insolvency

The COI is a probabilistic measurement which is expressed in decimal fraction between 0 and 1. Any value below zero indicates a highly solvent company. Values between zero and 1 indicate the degree of insolvency of the firm. Value of 1 (which is unlikely) indicates a bankrupt company while value 0 indicates a healthy company.
The possible stage of insolvency can be measured as follows:
. POI = OBEP * RSR
Where,
. POI = Point of Insolvency
. RSR = Relative Solvency Ratio
. OBEP = Operational Break-Even Point

The result of this measurement is expressed in number of production cycles. It simply tells us the number of production cycles that the present stock of working capital can cover before it is completely exhausted assuming no other fund comes by way of revenue or loan during the period.


References

  • Altman, E. I. (1983), Corporate Financial Distress – A complete guide to predicting, avoiding and dealing with bankruptcy, New York: Wiley
  • Anyigbo, C. I. (2004), “Strategic Management Accounting, Organizational Efficiency And Effectiveness”, Unpublished PhD Seminar Paper presented to The Department of Business Administration, Ebonyi State University, Abakaliki.
  • Bardia, S. C. (2006), “Liquidity Management: A Case Study of TISCO”, Towards Better Working Capital Management, Murthy, G. K. eds., Hyderabad, India: The Icfai University Press
  • Chakraborty, P. K. (2006), “Working Capital Management: A case study of Cadila Health Care Ltd”, Towards Better Working Capital Management, Murthy, G. K. eds., Hyderabad, India: The Icfai University Press
  • Doetsch, D. A. & Hammer L. A. (2002), “Observations On Cross-Border Insolvencies And Their Resolution In The Nafta Region”, United States and Mexico Law Journal, Vol. 6 @ www.mayerbrownrowe.com
  • Enyi, E. P. (2005),”A Macro Approach To Detection and Prevention of Corporate Insolvency – The Determinant Factors”, AAFM Journal Volume 7 Spring & Summer Edition @ http://www.financialcertified.com/journal.html
  • Enyi, E. P. (2006), “Applying Relative Solvency to Working Capital Management – The Break-Even Approach”, Towards Better Working Capital Management, Murthy, G. K. eds., Hyderabad, India: The Icfai University Press
  • Ezeagba, C. E. (2000), “An Analysis of Learning Curve Application on Cost Behavior of Manufacturing Firms”, Journal of Management Sciences, Awka: Vol. 3 No 2, June
  • Glautier, M.W.E & Underdown, B. (1997), Pricing In Accounting Theory And Practice, 6th Edition, London, Pitman Publishing
  • Harris, A. (2006), “Keys to Successful Working Capital Management”, Towards Better

Working Capital Management, Murthy, G. K. eds., Hyderabad, India: The Icfai University Press

  • Jafar, A. & Sur, D. (2006), “Efficiency of Working Capital Management in Indian Public Enterprises during the Post Liberalization Era: A Case Study of NTPC”, Towards Better Working Capital Management, Murthy, G. K. eds., Hyderabad, India: The Icfai University Press
  • Jutur, S. (2006), “Microsoft’s Cash Balance: How Much is too Much?”, Towards Better Working Capital Management, Murthy, G. K. eds., Hyderabad, India: The Icfai University Press
  • Morse, D.C. & Zimmerman, J.L. (1997), Managerial Accounting, Boston MA: Irwin McGraw Hill
  • Okeke, B. (2000), “Financial Management In Cooperatives”, Journal of Management Sciences, Awka, Vol. 3 No 2, June
  • Osisioma, B. C. (1997), “Sources And Management Of Working Capital”, Journal of Management Sciences, Awka: Vol. 2. January
This article is based on an article from Deletionpedia, where it ended up right before it was deleted from Wikipedia.