Question

3) The statement of financial position can be used to assess the following aspects of the reporting entity:

• liquidity

• asset mix

• financial structure (solvency).

(a) What do these terms mean?

(b) How could they be assessed from the statement of financial position figures?

(c) Which external stakeholders would have an interest in each aspect?

Answer 1

• A) Liquidity -This play a key role in assessing the short-term financial position of a business. Commercial banks and other short-term creditors are generally interested in such an analysis.

               Solvency :Solvency is a key metric used to measure an enterprise’s ability to meet its debt and other   obligations. The solvency ratio indicates whether a company’s cash flow is sufficient to meet its short-term and long-term liabilities. The lower a company's solvency ratio, the greater the probability that it will default on its debt obligations.

The measure is usually calculated as follows:

However, it is a comprehensive measure of solvency, as it measures cash flow – rather than net income – by including depreciation to assess a company’s capacity to stay afloat. It measures this cash flow capacity in relation to all liabilities, rather than only short-term debt. This way, solvency assesses a company's long-term health by evaluating its long-term debt and the interest on that debt.

• Asset Mix:Asset Mix is the composition of an investment portfolio which is determined based on risk-taking ability and life-cycle stage of an investor. Asset Mix is the combination of the three major asset classes – equities, fixed income, and cash and cash equivalents – in an investment portfolio.An Asset Mix is one of the first aspects an investor looks at while gauging the broad portfolio positioning of a mutual fund or an exchange-traded fund. It is typically presented in percentage form.

B)These ratios help in the determination of the liquidity,solvency and the asset mix of an organisation financial analysis.

Liquidity ratios asses a business’s liquidity, i.e. its ability to convert its assets to cash and pay off its obligations without any significant difficulty (i.e. delay or loss of value). Liquidity ratios are particularly useful for suppliers, employees, banks, etc.

However, managements can employ these ratios to ascertain how efficiently they utilize the working capital in the business. Shareholders and debenture holders and other long-term creditors can use these ratios to assess the prospects of dividend and interest payments.

This type of ratios normally indicates the ability of the business to meet the maturing or current debts, the efficiency of the management in utilizing the working capital, and the program attained in the current financial position.The following are the types of liquidity ratios which are available.

1.Current Ratio

2.Liquid Ratio

3.Absolute Liquid Ratio

4.Debtors Tunover Ratio

5.Creditors Turnover Ratio

6.Inventory Turnover Ratio

Solvency ratios assess the long-term financial viability of a business i.e. its ability to pay off its long-term obligations such as bank loans, bonds payable, etc. Information about solvency is critical for banks, employees, owners, bond holders, institutional investors, government, etc. Key ratios that can be calculated are as follows:

• Debt ratio
• Debt to equity ratio
• Debt to capital ratio
• Times interest earned ratio
• Fixed charge coverage ratio
• Equity multiplier

The asset mix can be applied to portfolio management in different ways. The majority of asset mix techniques fall within two distinct strategies – strategic asset mix and tactical asset mix.

Strategic Asset Mix is a more traditional approach to asset allocation that utilizes the tenets .The goal of strategic asset mix is to create a portfolio based on the investment goals and risk tolerances of the investor. Changes in the investment portfolio are usually only made when the portfolio becomes “unbalanced” due to fluctuations in the market, or the risk/reward profile of the investor changes, requiring an adjustment in the allocation.

Tactical Asset Mix is similar to strategic asset mix with a few noteworthy differences. Like strategic asset allocation, tactical asset mix is based on the assumption of the above.A tactical asset allocation strategy differs from value investing in that, instead of buying stock that is underperforming, one buys or adds to positions that are outperforming the broad market. So, in a portfolio that is tactically allocated based on relative strength, one can be significantly concentrated in particular market sectors.

C)Which external stakeholders would have an interest in each aspect

Owners/shareholders:Calculating returns if investing capital.

Lenders/financiers:Repayments and interest on loans or investment.

Suppliers:Likelihood of being paid.Future growth/survival prospects

Customers/clients:Prospects for the organisation remaining a supplier.

Donors:Cost-effectiveness

Government agenciesTaxation

Local communities:Source of local employment, or of local pollution or congestion

The general public:Context of employment or environmental concerns.

Competitors:Knowledge to inform their own strategies