CONTENTS
PART Ⅰ Foundations of Liquidity Analysis
CHAPTER 1 Introduction to Liquidity Management = 3
Corporate Objectives = 5
The Objective of Liquidity Management = 6
Profits versus Cash Flows = 8
Accounting Profits = 8
Cash Flows = 9
Economic Profits = 10
Residual Income = 11
What Lies Ahead? = 14
Summary = 14
Key Concepts = 15
Questions = 16
Problems = 16
CHAPTER 2 Economic Fundamentals for Analysis of Liquidity = 18
Economic Costs = 18
Time Constraints = 19
Immediate Time = 19
The Short Run = 19
The Long Run = 20
Physical Production Constraints = 20
Integration of Output and Costs = 24
Incorporating the Product Market = 26
Economic Concepts and Financial Statements = 28
Income Statement and Economic Profit = 29
Balance Sheet and Economic Stocks and Flows = 30
Economic Constraints = 31
Summary = 32
Key Concepts = 33
Questions = 34
Problems = 35
PART Ⅱ Financial Analysis of Liquidity
CHAPTER 3 Cash Flow Analysis = 41
Importance of Understanding Cash Flows = 42
Erroneous Definition of Operating Cash Flow = 42
Should Accrual Accounting Be Ignored? = 44
Overview of Calculating Cash Flow = 45
Preparation of Cash Flow Statement = 47
Sources and Uses of Resources = 47
Problems with Analyzing Balance Sheet Changes = 47
Changes in Retained Earnings = 49
Noncash Accounting Entries = 52
Changes in Fixed Assets = 52
Statement of Changes in Financial Position = 53
Statement of Cash Flows = 55
Summary = 57
Key Concepts = 57
Appendix: W. T. Grant Company's Financial Statements = 58
Questions = 61
Problems = 61
CHAPTER 4 Traditional Financial Analysis: Some Shortcomings = 68
Traditional Financial Analysis = 69
Liquidity Ratios = 69
Activity Ratios = 73
Coverage Ratios = 77
Profitability Ratios = 81
Standards of Financial Comparison = 85
Industry Comparisons = 85
Trend Analysis = 89
Warning Signals = 90
Quantification of Warning Signals = 90
Univariate Models = 90
Multivariate Models = 93
Quality of Earnings = 95
Fraudulent Actions = 96
Above-Average Financial Risk = 96
Less-Than-Conservative Accounting = 97
One-Time Transactions = 100
Borrowing from the Future = 100
Reaching into the Past = 101
Riding the Depreciation Curve and Other Factors = 101
Top Management = 102
Deferred Taxes = 102
Summary = 106
Key Concepts = 107
Appendix: Ratio Analysis for W. T. Grant Company = 108
Questions = 112
Problems = 113
CHAPTER 5 Off-Balance-Sheet Financing and Financial Analysis = 118
Motivation for Off-Balance-Sheet Financing = 120
Significance of Off-Balance-Sheet Financing on Ratios = 121
Unfunded Pension Liabilities = 122
Pension Put Option = 122
Financial Reporting Requirements = 123
Postemployment Benefits = 125
Leasing = 126
Financial Reporting Requirements = 126
Capitalizing the Lease = 127
Circumventing Disclosure = 128
Liquidity Analysis = 129
Sale of Accounts Receivable with Recourse = 132
Product Financing = 135
Insubstance Defeasance of Debt = 135
How It Works = 136
Pros and Cons = 138
Debt of Unconsolidated Subsidiaries = 140
Nonsub Subsidiary = 142
Project Financing = 143
Unconditional Commitment Agreements = 146
Interest Rate Swaps = 146
Summary = 147
Key Concepts = 147
Questions = 148
Problems = 148
CHAPTER 6 Indicators of Liquidity = 154
Return on Equity = 154
ROE Model = 156
Profitability = 157
Asset Turnover = 159
Financial Leverage = 161
Sustainable Growth = 164
Definition of Sustainable Growth = 164
Interpretation of Growth = 165
Responses to Sustainable Growth Disequilibrium = 166
Funds, Life Cycle, and Growth = 168
Cash Conversion Cycle = 170
Operating Cycle = 170
Definition of Cash Conversion Cycle = 171
Cash Conversion Cycle versus Traditional Liquidity Ratios = 173
Cash Conversion Cycle, ROE, and Growth = 173
Cash Breakeven Analysis = 174
Earning versus Cash Breakeven = 174
Cash Breakeven Formula = 176
Cash Breakeven, ROE, and Cash Conversion Cycle = 177
Inflation-Adjusted Financial Analysis = 178
Financial versus Physical Assets and Capital = 180
Use of Inflation-Adjusted Financial Data = 181
ROE Analysis = 183
Return on Sales = 184
Investment Turnover = 184
Leverage = 185
Growth = 185
Summary = 186
Key Concepts = 187
Appendix A: Relationship Between Residual Income and Return on Equity = 188
Appendix B: Calculation of an ROE-Maximizing Capital Structure = 189
Appendix C: Derivation of the Sustainable Growth Model = 194
Appendix D: Fundamentals of Current Cost Accounting = 196
Questions = 198
Problems = 198
PART Ⅲ Cash and Risk Management
CHAPTER 7 Overview of Cash Management = 203
Know the Cash Balance = 203
Problem with Accounting Procedures = 204
Types of Float = 204
Understanding the Check Process = 205
Corporate Policy = 208
Managing Cash Flows = 209
Accelerating Cash Inflows = 209
Concentration Banking = 209
Zero-Balance Accounts = 211
Lockbox Services = 212
Preauthorized Checks = 213
Preauthorized Debits = 214
Depository Transfer Checks = 215
Wire Transfers = 215
Automated Clearinghouse Debit Transactions = 217
Drafts = 217
Delaying Outflows = 218
Staggered Funding = 218
Remote Disbursement = 219
Controlled Disbursement = 219
Payable-Through-Drafts = 220
Automated Clearinghouse (ACH) Credits = 220
Role of Banks = 221
Bank Evaluation = 221
Willingness = 222
Ability = 223
Cost-Effective Operating Services = 223
International Cash Management = 223
Different Banking Environments = 224
Bank Fees = 224
Foreign Exchange Exposure = 224
International Funds Transfer = 225
Netting = 226
Reinvoicing Center = 226
Offshore Finance Company = 228
Summary = 228
Key Concepts = 229
Questions = 230
Problems = 231
CHAPTER 8 Minimizing Cash Balances = 235
Motives for Holding Cash = 236
Estimating the Level of Transaction Balances = 236
Ratio Projection Method = 236
Adjusted-Earnings Method = 237
Baumol Model = 237
Miller-Orr Model = 239
Estimating the Level of Precautionary Balances = 241
Cash Budget = 243
Daily Management of Cash Balances = 247
Miller-Orr Revisited = 247
Stone Model = 247
Daily Cash Forecasting = 249
Liquidity Indices = 256
Liquidity Flow Index (LFI) = 256
Relative Liquidity Index (RLI) = 258
Summary = 260
Key Concepts = 260
Appendix: Ad Hoc Procedure for Determining a Minimum Cash Balance = 261
Questions = 263
Problems = 263
CHAPTER 9 Duration Analysis and Hedging with Futures = 269
Rate-Sensitive Assets and Liabilities = 270
Duration Analysis = 272
Background on Futures = 274
Fundamentals of Hedging with Futures = 275
Cash Market = 276
Futures Market = 276
Mechanics of Interest Rate Futures = 277
Receivables Example Revisited = 279
Basis Risk = 282
Establishing the Hedge = 286
Summary = 287
Key Concepts = 288
Appendix A: Further Illustrations of Futures Hedging = 289
Appendix B: Mathematical Determination of the Hedge Ratio = 295
Questions = 297
Problems = 297
CHAPTER 10 Hedging with Options, Options on Futures, and Interest-Rate Swaps = 300
Options Versus Futures = 300
Fundamentals of Options = 302
Hedging with Options = 305
Hedge Ratio = 306
Hedging with Options on Futures = 306
Interest Rate Swaps = 311
Basics of Swaps = 311
Why Not Just Use Futures or Options? = 313
Why Not Refinance? = 313
Risk of Swaps = 314
Summary = 315
Key Concepts = 315
Appendix A: Overview of Some Other Hedging Instruments = 316
Appendix B: Mark to Market for Futures Contracts = 318
Questions = 319
Problems = 319
CHAPTER 11 Asset-Based Financing = 321
Conditions Conducive to Asset-Based Financing = 321
Marginal Creditworthiness = 322
Business Growth = 322
Business Seasonality = 322
Industry Cyclicality = 323
Financial Turnarounds = 323
Acquisition Financing = 323
Evaluation of Borrowers = 324
Cash Flow Analysis = 325
Analysis of Collateral = 325
Marketable Securities = 326
Accounts Receivable = 326
Pledging Accounts Receivable = 327
Factoring Accounts Receivable = 328
Securitization = 331
Inventory = 334
Types of Collateral = 336
Advantages and Disadvantages = 336
Fixed Assets = 337
Sale of Excess Property = 338
Pledging Plant and Equipment = 338
Mortgages on Real Estate = 338
Sale-and-Leaseback Agreement = 339
Tax Arrangement Exchange = 340
Sale of an Ownership Interest = 341
Pensions = 343
Plan Termination as a Source of Capital = 344
Indirect Sources of Capital = 346
Summary = 346
Key Concepts = 347
Questions = 348
Problems = 349
PART Ⅳ Trade Credit and Inventory Management
CHAPTER 12 Credit Selection Models = 355
Sources of Credit Information = 356
Credit Reporting Agencies = 356
Industry Interchange Reports = 357
Other Sources of Information = 358
Five C's of Credit = 358
Ad Hoc Scoring Model = 359
Evaluation = 360
Window Dressing = 360
Simple Probability Model = 361
Linear Discriminant Model = 364
The Model = 365
Concerns = 366
Sequential Decision System = 367
Summary = 372
Key Concepts = 373
Appendix A: Fundamentals of Discriminant Analysis = 374
Appendix B: Calculation of Indifference Values = 376
Questions = 381
Problems = 381
CHAPTER 13 Analysis of Credit Policy = 386
Theoretical Foundations = 387
Credit and Collection Variables = 388
Value of Cash Discounts = 388
Delayed Payment = 390
Asset, Liability, and Cash Flow Considerations = 392
No Credit Extended = 393
Credit Extended = 395
Important Considerations = 399
Steady-State Time Value Approach = 401
Explanation of $$I_0$$: Changing Credit Terms = 402
Explanation of $$I_0$$: Changing Credit Standards = 404
Reconciliation of the RI Model and the Balance-Sheet Approach = 406
Summary = 408
Key Concepts = 409
Appendix A: A Graphical Solution for Optimal Credit Terms = 410
Appendix B: Inflation-Adjusted Credit Model = 413
Appendix C: Comprehensive Credit Model = 415
Questions = 420
Problems = 420
CHAPTER 14 Monitoring Trade Credit = 424
Traditional Analysis = 425
Days Sales Outstanding = 425
Aging Accounts Receivable = 428
Use of Balance Proportions = 431
Interpretation of Balance Proportions = 431
Criticism of DSO and the Aging Schedule = 432
Variance Analysis Model = 433
Collection Experience Variance = 435
Sales Pattern Variance = 435
Sales Pattern Mix Variance = 436
Sales Quantity Variance = 437
Overall Analysis = 437
Changes in Payment Habits = 437
Internal Change = 438
Change in Product Mix = 439
Economic Conditions = 439
Later Payments = 439
Default versus Bad Debt = 440
Summary = 441
Key Concepts = 442
Appendix: Mechanics of Variance Analysis = 443
Questions = 446
Problems = 447
CHAPTER 15 Inventory Accounting and Cash Flow Effects = 452
Inventoriable Costs = 453
Definition of Inventoriable Costs = 453
Variable versus Absorption Costing = 454
Bases of Inventory Valuation = 456
Original Cost = 456
Lower of Cost or Market = 456
Standard Costs = 458
Selling Price = 459
Flow Assumptions = 459
First In, First Out (FIFO) = 460
Last In, First Out (LIFO) = 460
Comparison of Methods = 460
Advantages of LIFO = 464
Disadvantages of LIFO = 466
Summary = 467
Key Concepts = 468
Appendix A: Inventory Methods: Periodic versus Perpetual = 469
Appendix B: Inventory Accounting Errors = 471
Questions = 473
Problems = 474
CHAPTER 16 Inventory Investment: How Much? = 481
Need for Inventories = 482
Inventory Overinvestment = 483
Inventory Underinvestment = 484
Methods for Managing Inventory and Production = 485
Economic Order Quantity/Reorder Point Model (EOQ/ROP) = 485
Materials Requirement Planning Model (MRP) = 487
Just-in-Time (JIT) = 487
Reconciliation of the Methods = 488
Why JIT? = 490
Transitional Problems = 490
Target Inventory Balances = 491
A-B-C Method = 491
Inventory Turnover Ratios = 492
EOQ-Based Turnover Ratio = 495
Summary = 497
Key Concepts = 498
Appendix A: EOQ as a Wealth Maximization Model = 499
Appendix B: Extensions of the Classic EOQ Vendor Model = 501
Appendix C: Derivation of the EOQ Back-Order Model = 508
Questions = 509
Problems = 510
CHAPTER 17 Monitoring Inventory Balances = 513
Inventory Turnover Ratios = 514
One-Way Variance Analysis = 515
Two-Way Variance Analysis = 517
Three-Way Variance Analysis = 521
Incorporating Cash Flows = 527
Importance of Variance Analysis Relative to Turnover Ratios = 528
Summary = 531
Key Concepts = 532
Appendix A: Analysis of Variance Using Prior Year's Data = 533
Appendix B: Explanation of Mix and Quantity Variances = 535
Questions = 537
Problems = 537
PART Part Ⅴ Summary
CHAPTER 18 A Summary = 543
Economic Foundations = 543
Liquidity Analysis = 546
Management of Liquidity = 547
In Conclusion = 550
Appendices
APPENDIX 1 Forecasting Accounts Receivable Flows = 553
Analysis of Historical Patterns = 553
Constant Credit Risk = 554
Aging of Accounts = 554
Absorbing States = 557
Nonabsorbing States = 557
Transition Matrix = 558
Projections Based on Historical Payment Patterns = 558
Fundamental Matrix = 558
Probability of Payment = 560
Forecast of Receivable Balances = 562
Changing Credit Risk = 564
Timing of Liquidity Drain = 565
Liquidity Needs = 566
Summary = 567
Questions = 568
Problems = 568
APPENDIX 2 Corporate Bankruptcy, Reorganization, and Liquidation = 569
National Association of Credit Managers = 569
Corporate Bankruptcy and the Courts = 570
Reorganization in Bankruptcy = 571
Voluntary Reorganizations = 571
Tool for Restructuring Debt = 572
Procedure = 573
Reorganization Process = 574
Trusteeship/Receivership = 574
Revaluation of Assets and Reallocation of Claims = 575
Provision of New Capital = 575
Pros and Cons of Chapter 11 = 576
Liquidation = 576
Conclusion = 581
Questions = 582
Problems = 582
APPENDIX 3 Normal Probability Distribution Table = 583
APPENDIX 4 Time-Value Tables = 585
Glossary = 593
Selected Readings = 613
Answers to Problems = 619
Index = 631
