Financial Health in Terms of Profitabilty and Liquidity

Business
Basics
for
Engineers
by
Mike Volker
FINANCIAL HEALTH IN TERMS OF
PROFITABILTY AND LIQUIDITY

PERFORMANCE vs HEALTH
You may be a great performer, but...
I always like to tell the story of a fellow I knew who was regularly seen jogging
vigorously around town. He often ran competitively and was known for his speed and
stamina. One day, while jogging, he suddenly dropped dead at the age of 40. It turned out
that he had a congenital heart defect. What can we conclude about his performance?
What about his health? Whereas he was a great performer, he was obviously not in good
health. One of his key assets, his heart, just wasn't "worth" what it may have appeared to
be. On the other hand, in terms of performance, he was great! Companies are like this.
They may be great performers, but have a weak balance sheet. A company could have a
very strong balance sheet but be a lackluster performer.
Financial Performance
Performance is always measured over a time period. Corporations typically report their
performance on a quarterly basis. Internally, companies track their performance on a
monthly basis (some companies may even do this weekly or daily - or at least track
certain performance figures, like sales, on a frequent basis). The so-called Annual Report
is a requirement (imposed by governments and securities regulators) whereby firms
disclose their financial results on an annual basis - along with various other bits of
information which may be of value to shareholders.
The most important measure of performance is the Bottom Line. This is called the bottom
line because it is the bottom line which appears on a Profit and Loss Statement, also
called an Income Statement. The bottom line shows the amount of Net Profit (after taxes
have been paid) which the business has generated during that particular reporting period.
This number reports what the company has earned during the stated period of time. These
earnings are sometimes stated on a per share basis. This allows one to compare to other
companies by comparing their respective Price/Earnings ratios. Or, one could compare
companies by comparing their respective earnings expressed as a percentage of sales or
as a percentage of capital invested. For example, company ABC's earnings were 6% of
revenues as compared to 5% for the industry average. Or ABC's return on investment for
the period was 25% (i.e. earnings as a percentage of capital invested) as compared to its
main competitor which only returned 22% to its investors.
There are also non-bottom line numbers which are often important and need to be
studied. These would include gross margins (percent gross profit) or perhaps various
expenses, such as Research and Development expressed as a percentage of sales. If we
are producing communications systems with gross margins of 45% and R+D
expenditures of 9% and our competitor is achieving gross margins of 52% and R+D
expenditures of 8%, we better figure out what we're doing wrong.
In making comparisons to other companies, one should be careful not to compare apples
with bananas (like comparing Apple to Microsoft). The companies should be in the same
business (e.g. systems, software, hardware, communications, etc, etc). In any event,
depending on our management position in the organization, we will focus on those
performance measures which are important to us. The sales manager will be sensitive to
overall sales, sales expenditures, and gross margins. The production manager will be
concerned with cost of sales, gross margins, and operating expenses. The VP Engineering
will be concerned with development costs, unit costs, and margins. And, the CEO will
worry about everything.
Financial Health
A company's financial health is measured by taking a snapshot of its assets and liabilities at one
moment in time, usually at the end of a reporting period - such as at the end of a quarter or fiscal
year (what's a fiscal year?). How much cash is in the bank? How much is owed by the customers?
What are the debt obligations - to banks, suppliers, and others? How much capital has been invested?
How much has the company earned (or lost) to date (this item comes from the Profit and Loss
statement and is called retained earnings - that is the company's total earnings (net of any dividend
payouts) since its inception.
Financial Health is reported on the company's Balance Sheet. Balance Sheets and Profit and Loss
statements must always be considered together. One measures health and the other measures
performance.
Just as blood flows through the veins of a person, cash flows through the veins of a company.
Although a company's balance sheet may look strong (i.e. lots of assets and few liabilities), the most
important asset is cash and short term deposits, followed by cash to be realized within one month
(e.g. getting paid on recent sales). The cash-on-hand obtained from the balance sheet can be divided
by a company's monthly expenses to determine a rough estimate of how long the company can
survive at its current level of operation. Developing companies, such as biotech ventures, generally
have sufficient cash on hand that they can operate for years before having to generate income from
sales.
HOW TO ASSESS YOUR COMPANY.S
FINANCIAL HEALTH
We should do the same for your company? Financial statements provide the vital statistics
necessary to track a company.s health. Investors use financial statements to research potential
investments; bankers base lending decisions on a company.s financial statements; and valuation
experts utilize financial statements to determine a company.s worth. By routinely scrutinizing
your financial statements, you can monitor and improve your company.s performance and its
ultimate value.
A comprehensive financial analysis employs ratios to measure a company.s past and current
operations and compares the results to its industry. This type of review offers insight into the
historical growth, profitability, debt capacity, and overall liquidity of the subject company in the
context of its industry. All such factors can be important indicators of a company.s ultimate
value and provide useful information to business owners and managers who want to more
effectively and efficiently manage their operations.
You can perform your own financial checkup for your business. To begin, obtain a history of
your company.s financial statements. Five years worth is usually a good base. Next, convert
the financial statements to common size. Common size financial statements are simply your
company.s financials expressed in the form of percentages rather than dollars. A common size
format readily identifies trends and growth patterns. Additionally, since industry benchmark
data is often produced in this format, it makes it easier to compare your results with the
competition. Industry benchmark information can be obtained from a commercial vendor, your
accountant, or depending upon the industry, from trade associations.
Next, financial ratios are calculated. There are a number of ratios to choose from. Some of the
more common measure liquidity, debt coverage, leverage, and operating and profit
performance. Their relevance is dependent upon your company, its operating characteristics
and the industry. Bankers and accountants can be especially useful in identifying the more
pertinent ratios.
The information gathered thus far is analyzed and compiled on a trended, composite and
industry basis. The results of this analysis, when performed regularly, help you to monitor and
recognize the vital statistics necessary for the success and growth of your business. The
benefits of this assessment include:
Competitive Advantages & Disadvantages

An industry assessment enables you to identify your company.s strengths and weaknesses and
acquire valuable information on the competition.
Budgeting & Forecasting

Studying trends and growth patterns is a very effective preliminary step in preparing internal
budgets and forecasts.
Strategic Planning
Recognizing specific performance measurements (company and industry) will help to set goals
and objectives for the future (e.g., increasing sales, gross profit margins, and net income).
Acquisition Opportunities
Knowledge of key performance measurements assists in the evaluation of a proposed sale,
merger or acquisition.
Focus
Greater awareness of the interrelationship of the financial statements and a complete
understanding of financial operations allows you to focus on the areas important to the growth
and success of your business.
Regardless of whether you prepare or your accountant prepares, a financial analysis is akin to
your annual physical.it is crucial to understanding your company.s health.past, present and
future.
Measuring Financial Health
Definition
When measuring a business’s financial health we have to ask a number of questions. What is the
source of its revenue? On what does it spend its income, and where? How much profit is it earning?
The answer lies in a company’s financial statements and by law all public companies have to make
these statements freely available to everyone. Financial statements can be broken down into three
parts: the profit and loss statement (also called the income statement), the balance sheet, and the cash
flow forecast.
The profit-and-loss statement tells us whether the company is making a profit. It indicates
how revenue (money received from the sale of products and services before expenses are
taken out, also known as the “top line”) is transformed into net income (the result after all
revenues and expenses have been accounted for, also known as the “bottom line”). A
profit and loss account covers a period of time – usually a year or part of a year.
The balance sheet is a snapshot of a business’s financial health at a specific moment in
time, usually at the close of an accounting period. A balance sheet shows assets,
liabilities, and shareholders’ equity/capital. Assets and liabilities are divided into short
term and long term obligations. The balance sheet does not show the flows into and out
of the accounts during the period. A balance sheet’s assets should equal liabilities plus
owners’ equity.
The cash-flow forecast or statement identifies the sources and amounts of cash coming
into and going out of a business over a given period. In an established business, an
acceptable method is to combine sales revenues for the same period one year earlier with
predicted growth.
To survive, the organization’s total assets should be greater than its total liabilities.
Current assets (such as cash, receivables, and securities) should also be able to cover
current liabilities (such as payables, deferred revenue, and current-year loan and note
payments). If an organization’s cash and equivalents greatly exceed its current liabilities,
the organization may not be putting its money to the best use.
Advantages
• Profit and loss statements track revenues and expenses, so that managers and
investors can determine the operating performance of a business over a period of
time.
• Balance sheets can be used to identify and analyze trends, particularly in the area
of receivables and payables.
• A cash flow forecast shows where cash is employed or tied up. It is an early
warning indicator when expenditures are running out of line or sales targets are
not being met.
Disadvantages
• Profit and loss statements do not report factors that might be highly relevant but
cannot be reliably measured (for example: brand recognition and customer
loyalty).
• A balance sheet shows a snapshot of a company’s assets, liabilities, and
shareholders’ equity. It does not show the flows into and out of the accounts
during the period.
Action Checklist
• Use financial ratios on financial statements to evaluate the overall financial
condition of the business. Financial ratios help gauge viability, liabilities, and
projected future performance.
• Carefully analyze any profit and loss accounts for differences during the reporting
period. Anomalies might be due to seasonal or other variations or may indicate
deeper problems.
• Quantify in financial terms how decisions based on the financial statement could
impact on business.
• Financial statements cannot resolve all grey areas. Be prepared to consult and be
involved in a long and complicated process of analysis.
• Consult and question managers and key business stakeholders when evaluating
financial statements.
Dos and Don’ts
Do
• Make sure that you have used the financial ratios when analyzing financial
statements. If in doubt, consult an expert analyst.
• Check which accounting principles were used when drawing up the accounts.
Don’t
• Don’t assume that all financial statements truly reflect a company’s financial
position. Measuring and reporting permit considerable discretion and the
opportunity to influence results.
Liquidity
A high level of trading activity, allowing buying and selling with minimum price
disturbance. Also, a market characterized by the ability to buy and sell with relative ease.
Antithesis of illiquidity.
Easy convertibility into cash. A liquid asset or security can be easily bought or sold with
little or no impact on price. Most methods of counting money supply include some highly
liquid investments such as certificates of deposit. Liquid assets and investments are
highly desirable as they may be sold to allow an investor to enter other investments as
they arise. On exchanges, liquid investments usually have low bid-ask spreads. See also:
Illiquid, Liquidity preference hypothesis.
Liquidity. If you can convert an asset to cash easily and quickly, with little or no loss of
value, the asset has liquidity. For example, you can typically redeem shares in a money
market mutual fund at $1 a share.
Similarly, you can cash in a certificate of deposit (CD) for at least the amount you put
into it, although you may forfeit some or all of the interest you had expected to earn if
you liquidate before the end of the CD's term.
The term liquidity is sometimes used to describe investments you can buy or sell easily.
For example, you could sell several hundred shares of a blue chip stock by simply calling
your broker, something that might not be possible if you wanted to sell real estate or
collectibles.
The difference between liquidating cash-equivalent investments and securities like stock
and bonds, however, is that securities constantly fluctuate in value. So while you may be
able to sell them readily, you might sell for less than you paid to buy them if you sold
when the price was down.
What Does Liquidity Mean?
(1) The degree to which an asset or security can be bought or sold in the market without
affecting its price. Liquidity is characterized by a high level of trading activity. (2) The
ability to convert an asset into cash quickly. Also known as marketability.
Financial Crisis and New Dimensions of Liquidity
1. Introduction
The aim of the article is to stress the importance of market liquidity for the stability of the financial
system and the consequences in terms of prudential regulation and supervision, in the light of the
financial crisis that began in mid-2007.
We first analyze how the structural changes in the most important financial systems, and in
particular the process of financial innovation, have contributed to the huge increase in financial assets
as a result of two intertwined processes: firstly, the shift from the old-fashioned “originate-to-maintain"
to an “originate-to-distribute” (OTD) intermediation model, which has increased banks' credit potential
through the transfer of loans and credit risk to a larger group of investors. Secondly, the increasing
degree of involvement of non-bank financial intermediaries which, benefiting from a loosening of the
regulations, have been able to achieve a high degree of leverage on their investments in the new
financial instruments.
Financial innovation and the related securitization process have weakened banks’ ability to
manage liquidity risk in times of financial stress. Financial innovation has made banks and the other
financial intermediaries more reliant on the functioning and stability of financial markets, so that
liquidity, market and credit risks have become even more correlated. Moreover, the originate-todistribute
model, combined with the consolidation and diversification of financial intermediaries’
activities, has increased the interconnection of different intermediation levels, enhancing the systemic
and counterpart risks.
Regulation and supervision have proved inadequate to cope with this situation and must be
reconsidered at both the macro (scope and scale) and micro (instruments) level, also bearing in mind
the strong links between banks' solvency and liquidity.
To focus on the main lessons to be drawn from the recent crisis, we concentrate on the most
critical aspects of the present regulatory system and introduce the main reasons for rethinking liquidity
regimes, in the light of the changes which have taken place in the main financial systems, and their
consequences in terms of increased vulnerability to liquidity risk. The key question is: what went
wrong in the prevention of the liquidity crisis and the reduction of the contagion effect, and what
lessons can the regulators draw from the unfolding of the financial crisis?
The article is divided into four principal sections. The first is devoted to defining and depicting
concepts of liquidity and their evolution, focusing on the different forms liquidity risks may take. The
second analyses the transformation in the principal financial systems and the consequences of these
changes in terms of the growing complexity of operators’ liquidity management and their vulnerability
to liquidity risks. The third section focuses on the lessons for regulation and supervision arising from
the financial crisis as far as liquidity risk is concerned. Finally, the main conclusions of the article are
presented.
2. Definition and Evolution of the Concept of Liquidity

The difficulties in defining liquidity are clearly depicted by Crockett (2008): “Liquidity is easier to
recognize than to define”, reflecting the fact that, in the recent history of financial systems, economic
agents have used a large variety of financial instruments and techniques to plan and regulate their cash
needs. The definition of liquidity has therefore accompanied the evolution of the concept of money,
and has changed in response to the financial innovation process and, to a large extent, to the
modifications in the structure and functioning of the financial system.
Financial theory has illustrated that, given the imperfection of the capital markets, the transfer
of resources between economic agents and across time requires an adequate amount of risk-free
financial assets in the economy: stores of value, means of transferring purchasing power generally
accepted by operators. A State-provided financial asset is able to acquire the monetary function of unit
of account and medium of exchange. i.e. a form of outside liquidity represented by a liability of the
27 Journal of Money, Investment and Banking - Issue 8 (2009)
Central Bank, which has taken on the role of creating money and regulating the amount in circulation
on the State’s behalf.
Financial theory also explains the role of banks as liquidity providers: their function of granting
loans or holding primary debt securities issued by economic agents with funding needs is accompanied
by the function of collecting resources from investors by issuing “indirect debt securities”, which by
reason of their maturity, divisibility and other contractual characteristics, are considered and generally
accepted as a substitute, in virtually all respects, for the legal tender (monetary base). This has led to
the definition of a concept of banking liquidity, which includes the liabilities at sight of the banks and
the liquidity produced by issuing lines of credit.
Banking liquidity risk is therefore associated both to banks’ ability to fulfill their obligation to
depositors (borrowers) to transform their deposits into legal money (to receive cash by drawing down
the credit lines), and their function of maintaining a balance between the ingoing and outgoing cash
flows deriving from the management of payments made using banking money1. Means of payment are
created and cash flows managed under the direction and control of the Central Banks, which guarantee
the availability of the monetary base needed to sustain the ordered creation of banking money. The
Central Banks also play a key role in the creation and strengthening of the infrastructures needed to
settle payments within the financial system.
During the last few decades the rapid development of the financial markets, and especially the
growth in the role of secondary markets in securities, has triggered a broadening of the spectrum of
financial assets which can be included in the definition of liquidity. We are therefore witnessing the
adoption of a concept of market liquidity, according to which the degree of liquidity is assessed on the
basis of a number operating characteristics concerning securities markets (Bervas, 2006):
• the transaction costs as measured by the bid-ask spread of securities’ trading;
• the market depth, i.e. the volume of transactions that may be immediately executed without
slippage of best limit prices;
• the market resilience, i.e. the speed with which prices revert to their equilibrium level
following a random shock in the transaction flow.
The aforementioned characteristics of market liquidity are usually fulfilled by organized
markets whose functioning is based both on the trading of large-issue standardized financial assets, and
on the large-scale distribution to investors of high-quality information on asset trading and the issuing
agent. Furthermore the organized markets depend on the role of intermediaries in providing liquidity
and trading immediacy services.
The definition of market liquidity clearly underlines the transformation that has taken place in
liquidity risk, which is increasingly linked to the functioning of the market and the ability to raise the
required monetary funds, either by selling financial assets held in portfolio or by issuing new financial
instruments (or some mix of the two).
The changes in the cash flows associated to financial assets – and thus closely correlated with
variations in the credit risk – as well as the instability in the functioning of the market itself, can
jeopardize the sale of financials asset at the expected value, and the possibility of refinancing the
portfolio of such assets on the market: funding liquidity risk. At the same time, funding liquidity is
critical for the smooth functioning of asset trading, and it can become scarce at times of financial
distress, precisely when it is most needed, as financial intermediaries hoard liquidity by cutting credit
lines and/or raising margin requirements to protect themselves against counterparty risks. The market
liquidity risk is thus aggravated by the portfolio adjustments made necessary by operators’ balance
sheet constraints, such as the maintenance of a given level of leverage, or the restoration of the margins
required of the holders of financial assets by financiers. Therefore the inefficient provision of liquidity
in financial markets “can generate a cash-in-the market pricing effect…when even the prices of safe
assets can fall below their fundamental value and lead to financial fragility” (Allen and Carletti, 2008,
p.11).
In the light of the definitions provided above, the important role played by liquidity risk in the
development of the current financial crisis can be traced to the systematic underestimation of the
growing market liquidity risk by both market agents and the supervisory authorities. The rapid rate of
financial innovation, which has made it possible to securitize financial assets which were originally not
tradable, such as bank loans, has fed operators’ expectations to cover liquidity needs by creating new
financial assets, or disposing of the financial assets they hold. Asset transferability was considered as
equivalent to the ability to trade an asset, converting it into money, quickly and at low cost with little
impact on its price. In the operators’ view, liquidity was no longer limited to the monetary base and
sight deposits, but rather included the financial market in its entirety. Therefore the definition
according to which “an asset offers liquidity to the corporate world if it can be used as a cushion to
address pressing needs” (Tirole, 2008) was proven by broader monetary/credit aggregates and,
according to some authors (Adrian and Shin, 2007), liquidity actually consists of the total assets of
financial intermediaries’ balance-sheets.
3. Financial Deepening and the Increase in the Liquidity Risk Level of Financial
Circuits
The emergence of liquidity risk in the ongoing financial crisis is therefore the outcome of two closely
interconnected processes. The first is the greater “financial deepening” of the main economic systems,
where the volume of financial assets has grown not only at a faster rate than economic activity, but also
more rapidly than the liquidity created by banks in the form of deposits. Through the securitization of
bank loans, financial innovation has not only encouraged greater indebtedness in the private sector, and
the consequent creation of financial assets, but has also modified these assets’ composition through the
issue of negotiable securities on unregulated markets, giving agents the perception of a higher degree
of liquidity.
The second process was the growth of a parallel financial circuit, integrated with the banking
circuit, encouraged by a lower level of regulatory constraints and above all by lower capital
requirements; this alternative trading circuit not only increased the volume of financial assets per unit
of resources transferred to the final sectors, but also made the system more vulnerable to financial
shocks.
The starting point for our analysis is the evolution of overall financial aggregates and especially
their growth in relation to the trend in economic activity. Figure 1 plots the ratio between the total
financial assets of the domestic sectors (non-financial private sector, financial private sector and public
sector) and GDP for the euro area2, UK and the US. The indicator reveals an acceleration in financial
aggregates compared to the trend in economic activity: the ratio for the period 1999-2007 increases
from 6.7 to 9.1 times GDP in the United States, from 8.7 to 13.4 times in UK and from 5.4 to 8 times
in the euro area. This growth becomes particularly striking from 2002 onwards in the UK and, even to
a less extent, in the euro area and in the US, after the crisis that hit the financial markets at the start of
the decade.
2 As for euro area we consider the 15 countries for the period 1999-2007 and the 4 most important euro
countries –
Germany, France, Italy and Spain - for the period 1995-2007.
Degree of financial leverage for the primary US banks (Ratio between total assets and equity
capital)
Investment Banks Commercial Banks
Goldman
Sachs
Morgan
Stanley
Merrill
Lynch
Lehman
Brothers
JP Morgan
Chase Citigroup BOA Wells
Fargo
The growth in the banking circuit and the other categories of financial intermediaries involved
an expansion in use of the bond market, and the issue of negotiable instruments originating in
securitization operations.
In the euro area, the banks themselves have increased their recourse to the securities market: the
ratio between securities issued and GDP increased by about 10 percentage points during the period
(from 26% in 1999 to 36% at the end of the period), while in the United States and in the UK non-bank
financial intermediaries account for most of the increase in securities issues. The data starting since
1995 allow assessment of the long-term shift towards the increasing securitization of the financial
system and the central role played by financial intermediaries as driver of this process.
This trend towards a closer symbiosis between intermediaries and market has been accentuated
in recent years, as a consequence of the new phase of financial innovation, with its explosion of risk
transfer instruments, which has accentuated the process of diversification of intermediaries. Banks
have been amongst the players that have diversified their operations most energetically, but even
portfolio investors, such as insurance companies and pension funds, and investment banks, have
diversified into areas that used to be the exclusive domain of credit originators, notably banks.
Likewise, there are few substantive differences between the activities of the proprietary desks of the
larger commercial and investment banks and those of smaller, independent institutional investors such
as hedge funds and private equity financiers (Knight, 2004).
As a result of the increasing diversification of assets, large financial groups adopted similar
business models, their activities became more interrelated, and the values of assets more correlated,
with the effect that negative disclosure by one operator has contaminated others (contagion effect).
Therefore, the OTD model has certainly distributed risks more broadly across the financial system, but
it has simultaneously increased the homogeneity of financial portfolios, thus accentuating the systemic
component of financial risk (Wagner, 2007).
In their distribution of the loans they have originated and securitized, the banks have made use
of, and helped to fuel, a financial asset trading circuit based on SIVs specializing in the intermediation
of new financial instruments. In the USA, the proportion of securities issued by SIVs has risen to 39%
of total issues. Moreover, asset backed commercial papers account for the majority of the commercial
papers issued .
The innovation process went hand-in-hand with a reduction in the relative weight of customers’
deposits, i.e. the bank funding component capable of guaranteeing the highest degree of stability and
predictability in terms of liquidity. In the United States, the deposits/securities ratio decreased from
0.77 times in 1995 to 0.49 in 2007 (Tab. 4). The deposit disintermediation was particularly intense and
concentrated in the second half of Nineties: only in the period 1995-1999 the ratio decreased by 20
percentage points (from 0.77 to 0.57). A similar more recent trend can be found in Europe, although
33 Journal of Money, Investment and Banking - Issue 8 (2009)
the importance of deposits as source of funds was much higher; the ratio for the 4 main countries of
euro area decreased from 3.4 in 1995 to 2.30 at the end of the period. The reduction can be traced to
the growth in securities issued both by bank and by non-bank financial intermediaries. Also the UK
banks registered a very intense deposit disintermediation with a ratio which decreased from 6 to 4.2
times the value of issued securities.
The evolution of the financial picture outlined above emphasizes the systemic and
multidimensional risk implications of an intermediation model based on the credit risk transfer. In
particular the poor liquidity of credit risk transfer instruments along with the growth of financial
circuits based on an higher leverage degree have accentuated the link between credit risk, market risk
and liquidity risk. The sequence of the events that brought to the present financial crisis makes evident.
The OTD model has considerably expanded the credit supply, by transforming into securities
the loans granted to households, even those with low solvency levels (subprime loans) and leveraged
loans sourced from corporate mergers and acquisitions and leveraged buyouts. The creation of more
complex, differentiated financial instruments was intended to meet the demand for a broader range of
risk and return combinations, but this was at the expense of the standardization and tradability of
financial assets. Thus the production of transferable financial assets through securitization – in the
form of credit risk transfer (CRT) instruments, such as Asset Backed Securities, Collateralized Debt
Obligations, Collateralized Loan Obligations enabled the selling of bank loans, but did not ensure the
liquidity of secondary markets.
As defaults of subprime loans started to increase at the beginning of 2007, investors began to
pull back from direct investment in CRT products, as well as from the commercial paper market which
backed SIV and conduit activity. Spreads in secondary markets widened firstly for subprime related
products and subsequently across a range other CRT products: the price plunge reflected discount for
uncertainty about future collateral performance and market illiquidity (Bank of England, 2008). The
difficulties encountered by the SIVs and the other financial intermediaries in refinancing their loans
through new commercial paper or bond issues led to a growth in the demands on the financial lines
used by the banks themselves as guarantees. The additional liquidity was required to provide support to
the SIVs and conduits they had sponsored, to enable drawing of the back-up credit guaranteed to
finance M&A operations and buy outs, and also to comply with the contractual clauses incorporated in
the securitization of credits (for example the credit rating downgrade clause and call features). From
the commercial paper market, the liquidity shortages spread to the interbank market as banks tried to
fund unexpected warehoused exposures in the leveraged loan, subprime RMBS and CDO markets. In
this way a credit event turned into a liquidity event.
Simultaneously, the liquidity crisis affecting the unregulated structured securities markets was
rapidly transformed into a solvency crisis affecting the banking system. The deleveraging of portfolios
triggered a downward spiral in the prices of market instruments which forced write-downs of loans and
securities portfolio, also due to the adoption of fair value accounting, increasing banks’ degree of
indebtedness and making the need to recapitalize them more urgent. Banks’ higher solvency risk, and
the consequent greater counterparty risk, thus led to the substantial paralysis of the interbank market
and financing on the bond markets.
The Lessons for Financial Regulation and Supervision
The genesis and development of the current financial crisis share some common features with other
financial crises, but are unique in several respects, key amongst these the liquidity shocks and tensions
deriving from the more complex liquidity risk in today’s markets.
In a financial context characterized by a closer nexus between credit risk, market risk liquidity
risk and also counterparty risk, the current regulatory and supervisory frameworks have proved to be
inadequate in the new financial environment in fully understanding the degree of interdependency of
the risks affecting the various components of financial intermediation, and in monitoring the financial
situations and risk-taking behaviours of individual financial intermediaries.
With regard to liquidity, the need for authorities to take a system-wide view implies the ability
to give answers to the problems that have arisen from the transformation of the financial scenario
outlined in section 3. The main issues are related to the following aspects, which will be analyzed in
detail in this section:
• the growing interconnections between credit risk and liquidity risk against the background of
the Basel 2 regulatory framework, in which the solvency rules are international in scope
(although with various limitations), contrasting with the national character of liquidity regimes;
• the emergence of a market liquidity risk related to new financial products traded in OTC
markets;
• the redefinition of the role of monetary policy, and of the lender of last resort function in
particular, consequent on the development of CRT products and the increase in the number of
categories of financial intermediaries involved in the securitization process.
The Nexus between Solvency and Liquidity: Rethinking Basel 2
Solvency and liquidity regulation has traditionally been a key responsibility of bank regulators and
supervisors, undertaken to preserve the soundness and financial stability of individual banks and
reduce excessive exposure to macroeconomic shocks, so as to limit bail-out actions and massive
liquidity injections by Central banks.
Since the end of the Eighties, prudential regulation of financial institutions has relied on capital
adequacy to cope with the financial risks confronting banks. An international capital adequacy regime
for credit risk (and thereafter market risk and now operative risk) has been developed by the Basel
Committee on Banking Supervision within the framework of Basel 1 and, in the last decade, of Basel
Liquidity risk has not been directly considered in the Basel capital adequacy framework. This
approach reflects the idea that, in all events, a strong capital base should restrict the impact of liquidity
shocks. As is very well known, capital adequacy may provide some reassurance to market participants,
but even well capitalized banks can face severe liquidity problems in exceptionally adverse conditions
(Revell 1975). Therefore, liquidity requirements must be considered as a complement of solvency
ratios.
The transition from Basel 1 to Basel 2 was necessary because the growth of new financial
players and their contribution to the financial innovation process, as described in the previous
paragraph, require a more comprehensive, homogeneous set of rules to level the field of competition
and restrict regulatory arbitrage on risk capital. Basel 2 has introduced capital requirements for (OBSEs)
in Pillar 1, while Pillar 3 requires disclosure of the securitization
process.
It may be argued that if Basel 2 had already been in place, especially in the USA, the crisis,
even if not avoided, could have been less severe. However, the financial crisis revealed severe flaws in
Basel 2, at a stage when it has not yet been definitively implemented, especially with regard to the role
of rating agencies in the delegated monitoring process, the procyclical effect of the capital ratios
regime, some aspects of the securitization process and finally the perimeter for application of the
accord. The regulators are rethinking some aspects of Basel 2 in the light of the flaws which have been
emerged.
While on the one hand Basel 2 limits the expansion of structured credit products traded in OTC
markets, with the aim of reducing regulation-circumventing behaviours linked to securitization
processes, on the other it provides only partial solutions to the liquidity problems linked to the
development of the new financial products.
In fact Basel 2 introduces or reinforces a narrow set of rules addressing some liquidity risk
profiles of financial intermediaries. One first aspect concerns the fact that Pillar 1 requires banks to
maintain capital to support liquidity commitments to OBSEs, even if their duration is less than one
year. However these commitments are considered as senior exposures with lower capital charges for
shorter maturities. In order to avoid regulatory incentives for the creation of OBSEs, banks should be
required to apply higher weightings to the liquidity lines extended to securitization vehicles, thus
increasing the level of capital required (Vento, La Ganga 2008).
The aim of Pillar 2 is to strengthen banks’ risk management practices (Resti 2008). To this end,
financial intermediaries are required to establish an internal system (Internal Capital Adequacy
Assessment Process, ICAAP) to determine the total capital they need to cope with the full range of
risks undertaken, among them liquidity risk, not considered in Pillar 1. Supervisory Authorities have
the task of assessing the degree to which internal targets and processes incorporate the full range of
risks faced by the bank: the Supervisory Review and Evaluation Process (SREP). Supervisory
Authorities may require banks to increase the regulatory capital determined in Pillar 1, for two main
Journal of Money, Investment and Banking - Issue 8 (2009) 36.
purposes: to take into account risks not included in Pillar 1, including liquidity risk, and to cope with
risks that have not been satisfactorily measured. Nevertheless, these measures feature a high degree of
discretionary power in the supervisory review process. The coordination of the actions envisaged by
Pillar 2, through internationally accepted guidelines on both supervisory activities and liquidity risk
management practices, should be a considerable step forward.
The purpose of Pillar 3 is to complement the minimum capital requirements (Pillar 1) and the
supervisory review process (Pillar 2) with market discipline. To this end a set of disclosure
requirements are developed to allow market participants to assess risk exposures, risk assessment
processes, and therefore the capital adequacy of banks. The securitization process is amongst the areas
subject to compulsory disclosure: the intention is to introduce improvements in response to the
information shortfalls which emerged during the crisis. However, no specific provisions are made for
liquidity risk profiles.
Fundamentally, Basel 2 acts on innovation processes in two main ways: in the first Pillar, by
reducing regulatory arbitrages and strengthening capital adequacy in response to risk transfer
processes, and in Pillar 3 by requiring the public disclosure of these processes. Apart from the
necessary adjustments and improvements, liquidity risk is only dealt with in relation to the capital
requirements linked to banks’ liquidity commitments and the supervisory review process in Pillar 2, in
an approach which is still based on discretionary action by the individual supervisors.
Liquidity Risk: Beyond Basel 2
The fact remains that Basel 2 is not a regulatory instrument capable of overcoming the problem of
liquidity risk, except indirectly to the extent that it deals with the relative risk profiles of risk transfer
processes. The crucial problem lies in the different liquidity regimes which, unlike the regulatory
frameworks for capital adequacy, have developed along national lines with different quantitative and
qualitative rules and levels of disclosure. These elements are related to and affected by the national
regulatory context, such as insolvency regulations, national deposit insurance schemes, and the
monetary policies implemented by central banks.
A recent survey by the Basel Committee on Banking Supervision (2008a) on the state of
liquidity regimes reports that, in spite of common general liquidity supervision objectives, there are
differences in the national approaches due to different mixes of quantitative and qualitative rules.
In some countries, the authorities’ emphasis is more on traditional quantitative approaches, with
the definition of specific rules and the setting of liquidity buffers that banks are required to hold. Banks
are obliged to maintain specific minimum liquidity parameters, and to meet targets such as limits on
maturity mismatches or reliance on a particular funding source, liquidity ratios, cash capital positions
and long-term funding ratios.
Nevertheless, the increasing awareness that inflexible quantitative rules could be ineffective in
a financial situation of stress has recently led some supervisory authorities to turn to qualitative
approaches, based on reviewing and strengthening banks’ internal risk management systems (Panetta
and Porretta, 2008; Tarantola, 2008). Under this approach, banks are required to develop and document
internal systems for the management, control, monitoring and reporting of liquidity positions,
identifying specific measurements of liquidity risks, to be periodically validated by supervisors.
Increasing importance is given to stress tests and contingency funding plans used to deal with stress
scenarios, with indication of management responsibilities, procedures and the potential sources of
liquidity adopted.
In some countries, a two-tier system emerges and different rules are set for large and small
banks, with a more sophisticated, flexible approach set for the former, and more prescriptive,
standardized rules for smaller banks. Usually, the intensity of supervision tends to increase for larger,
more systemically important financial intermediaries, in proportion to the assumed increase in risk. In
some countries, bigger banks are required to hold a larger buffer of liquid assets compared to smaller
banks.
In recent years, larger banks have increased the role of scenario analysis and stress tests in
evaluating risks and have developed contingency funding plans. The development of these
methodologies is still at an early stage and they turn out to be heterogeneous and often based on a
judgmental approach. With specific regard to liquidity risk, it emerges that stress tests carried out
before the crisis failed to identify potential weaknesses and vulnerability in banks’ liquidity positions
(Rosemberg, 2008). The main problem was that these tests omitted critical linkages, such as those
between credit risk, market risk and liquidity risk. Moreover the tests mainly focused on idiosyncratic
or firm-specific shocks (Basel Committee on Banking Supervision, 2008a and European Central Bank,
2008b). The main lesson is that stress testing must focus on the combination of idiosyncratic and
market-wide shocks, in order to pick up the implications of wider market disruptions. The task for
supervisory authorities is to promote more standardized, rigorous, comprehensive stress testing.
Contingency funding plans are set up to outline strategies to be followed by banks in the event
of stress scenarios. During the crisis they appeared to be insufficiently robust, with the inclusion of
liquidity sources that proved to be unavailable in a situation of generalized stress and central bank
refinancing, without considering the reputation risk arising for banks utilizing this source. On this
point, the crisis revealed that there is still a “stigma” attached to central bank standing facilities: fearing
that depositors’ confidence could be damaged, banks may be reluctant to request central bank facilities,
thus worsening interbank market conditions and increasing the risk of turning a liquidity crisis into a
solvency one (International Monetary Fund, 2008a).
In all the regimes surveyed, the supervisory authorities require banks to report information on
their liquidity positions. Nevertheless, public disclosure of banks’ liquidity positions has also emerged
as a key aspect of the financial crisis: usually public disclosure is not defined by regulatory
requirements, and is limited to the disclosure required by accounting rules and the rules applicable to
public traded companies.
The fragmented nature of the national liquidity regimes has made the international system more
fragile and more vulnerable to systemic shocks. The authorities need on the one hand to create a shared
framework of liquidity rules and on the other to coordinate supervisory practices, with more decisive
action by supervisors on the structuring and validation of the liquidity risk management techniques
adopted by banks, with particular reference to systems of stress tests and contingency plans.
Another area for intervention is coordination and information-sharing between the supervisory
authorities, aspects of particular importance with regard to the liquidity risk management practices of
large financial groups operating across jurisdictions, sectors and subsidiaries.
A survey by the Basel Committee on Banking Supervision – The Joint Forum (2006) reports
that for these intermediaries, regulations may have an impact on the definition of liquidity management
risk strategies. The risk of contagion within a banking group leads national authorities to require
separate pools of liquidity for each individual entity and restrict intra-group exposures. The regulatory
constraints limit banks’ ability to centralize liquidity risk management and their options for dealing
with crisis situations, generating challenges in transferring funds and securities across borders and
currencies, especially on a same-day basis.
Market Liquidity Risk
The evolution of US and European financial systems outlined in section 3 stresses the importance for
regulators of the increasing market liquidity risk related to the large spectrum of financial instruments
originated by the securitization activity of banks and other financial intermediaries. As mentioned
before, one important implication of financial innovation is that the smooth functioning of the financial
system is more and more dependent on the assumption that the financial instruments held in portfolio
could be traded (and new securities could be issued) even under stressed market conditions.
The problem of the liquidity of financial instruments such as CDOs and RMBSs has been
aggravated by the fact that those instruments are traded in over-the-counter markets and not in
organized exchanges. The importance of OTC markets for these kinds of instruments has mainly arisen
Journal of Money, Investment and Banking - Issue 8 (2009) 38
from banks’ double role as the securities’ originators and as trading counterparties in OTC markets,
allowing them to earn fees less likely in organized exchanges.
Evidence is given by Cecchetti (2007) that in the event of a liquidity crisis, exchange–based
trading works more smoothly than OTC markets; moreover liquidity crises in OTC markets are more
systematic in their effects. He cites the markets’ different reactions to news concerning solvency
difficulties of financial intermediaries, as proof of this hypothesis. A genuine financial crisis was
triggered in 1998 by LTCM, which had its exposure concentrated in swap contracts traded on the OTC
market. On the other hand, in 2006 the failure of Amaranth Advisors, a hedge fund specializing in
energy futures, provoked a “yawn”.
Organized exchanges require participants to hold margins in order to maintain positions;
moreover an equivalent of capital requirement is set for non-bank participants, while the provision of a
clearing house reduces the counterparty risk. Organized markets tend towards a greater standardization
of financial contracts, and thanks to enhanced transparency they also create the conditions in which
contracts will be more negotiable in case of distress.
Monetary and regulatory authorities are showing great interest in market liquidity and the
working of OTC markets. There may be a need for the strengthening of regulation, intended to
structure financial markets in a way that minimizes systemic risk. The introduction of organized
exchanges, with standardized financial contracts, for specific kinds of financial instruments may be
envisaged (Eichengreen, 2008). In fact, in the present crisis, the presence of a clearing house could
have reduced the counterparty risk, thus encouraging the trading of credit risk transfer instruments.
Scale and Scope of the Lender of Last Resort Function
When financial instruments are no longer backed by liquidity and there is an increasing funding
liquidity risk, the role of lender of last resort (LLR) played by Central Banks becomes crucial. Since
the beginning of the crisis, Central Banks have repeatedly rapidly intervened, on the one hand by
increasing the range of assets which can be considered as collateral for loans granted, and on the other
by extending the types and amounts of the lines of financing of last resort available. The extraordinary
intervention has been intended to support the financial institutions in distress both by offsetting the
liquidity shortfall on the financial markets and by smoothing liquidity conditions in the interbank
markets, thus avoiding even more severe disruptions of these markets.
With regard to liquidity support, the lesson from the recent turbulence makes it necessary to
focus on two main issues: collaterals, with respect to the broadening of the variety and extension of
operations’ maturity, and the widening of the range of counterparties (Goodhart, 2008).
Regarding the first point, it emerged that the Central Banks best able to cope with market
turbulences were those using a wider definition of acceptable collaterals. The issue is how far the range
of eligible assets should be widened to include innovative, less traditional instruments. To this end
Bagehot’s principle (1873) is even more apt and must be borne in mind: lend freely but at a high rate
against good collaterals.
Once the actual emergency is over, a delicate balance must be achieved between the widening
of the range of eligible assets and their quality level. The issue of the quality of eligible assets is of
importance in protecting the lenders, central banks, from credit and counterparty risks. Financial
innovation, and in particular the spread of CRT instruments, makes it necessary to set a wider
perimeter for the types of financial assets eligible as collateral for lending of last resort. The monetary
policy authorities should adopt eligibility rules capable of providing incentives for banks to engage in
less risky speculative lending activity and to hold “high quality” paper as collateral for credit and
liquidity risk (International Monetary Fund, 2008a).
.
Conclusions
The main lesson of the current financial crisis is that liquidity risk is once again a central topic for the
stability of the financial system, due to the transformations in the functioning of financial systems
which have taken place during the last few years. Financial innovation has allowed credit risk to be
transferred to final investors by means of the financial market. As a consequence, the links between
credit, market and liquidity risks have become tighter, while the effects of a crisis originating in any
point of the financial system have become systemic. Therefore both financial intermediaries - in their
risk management models – and regulators – in the structure of their controls and supervisory measures
– must rethink the connection between solvency and liquidity. On the one hand, sound liquidity risk
management helps to reduce the likelihood of insolvency problems. On the other hand, especially
under severe market conditions, the ability of a bank to obtain liquidity may depend on its capital
adequacy.
The international framework on capital adequacy can be further improved with regard to the
securitization process and some liquidity profiles, but it cannot solve the problem of the fragmentation
of liquidity regimes. Level-playing field and competition issues support the case for the harmonization,
or at least coordination, of national regulations and supervisory practices, and for the promotion of
sound, internationally consistent liquidity management practices, especially for large banks and
financial conglomerates. To this end, one critical aspect deals with the development of robust stress
testing and effective contingency funding plans more integrated and focused on the combination of
idiosyncratic and market-wide shocks.
At the macro level, the need emerges for regulatory measures to increase the transparency and
liquidity of the markets on which credit risk transfer instruments are negotiated, to guarantee more
orderly conditions for the portfolio adjustments of intermediaries suffering liquidity stress. The
authorities should show at least as much attention to markets’ liquidity as they do to the functioning of
payment systems. In other words, there should be an expansion of liquidity control, involving the
functioning, and thus the efficiency, not only of the monetary market but also of the financial market.
Journal of Money, Investment and Banking - Issue 8 (2009) 40.
The monetary authorities’ intervention has focused on a widening of collaterals, an extension of

maturities and an expansion in the number of counterparties. On this point, several issues emerge: on
the one hand, the possible transfer of credit risk to Central Banks due to the enlargement of the range
of eligible assets, and on the other hand, the scale and scope of their function as LLR, and the
boundaries with regard to the institutions subject to regulation.
The characteristics of the recent financial crisis, with the emergence of a systemic liquidity risk,
give grounds for the idea that “… in a globalised world with growing interdependencies, the general
field of vision must be broader than in the past” (European Central Bank, 2008a, p.19) and requires a
wider rethink of the design of regulation and supervision at the national and international level, with
regard to the architecture of supervisory authorities, their fragmentation in some contexts, and also the
boundaries of their jurisdiction. One crucial element stems from the ever-increasing integration of
banks and markets, and the consequent implications for systemic risk, since it is becoming more and
more difficult to isolate banking risks from capital market risks (Boot and Thakor, 2008). In a growing
number of cases, the implications for bank safety of a crisis in the capital market are justifying bailouts
even of uninsured participants, including investment banks and capital market investors.
The excessive fragmentation of responsibilities, the different degree of control, or lack of it, for
intermediaries in the mortgage business, under-regulation for investment banks, and the development
of nearly unregulated institutions (hedge funds) were at the root of the crisis in the US.
As far as the European Union is concerned, the creation of cross-border and cross-sector
financial groups, the growing integration of the financial markets (especially in the euro area), and the
broader trend to globalization, are all factors demanding a thorough reconsideration of the architecture
of controls. While on the one hand we are witnessing pan-European financial regulation, dictated by
the EU Directives on banking-finance-insurance, on the other the approaches, practices and
supervisory structures continue to be different in the various member states, with considerable
fragmentation (European Central Bank, 2006). In the event of a crisis, the problem arises of adequacy
of information sharing and cooperation between the various supervisors, the European Central Bank
and the national Central Banks. Even greater problems arise from the management of crises affecting
cross-border intermediaries.
When events started to snowball in autumn 2008, the authorities found themselves forced to
deal with the shortcomings of the existing regulatory structure, and responsibilities were assigned on
the basis of the specific crisis in hand, under a voluntary coordination mechanism (Ecofin, 2008): the
ECB handled the liquidity crisis, while the national supervisory authorities intervened in cases of
imminent insolvency, with Government rescue measures funded from the public purse. Due to the
fragmentation of the supervisory authorities, in the case of cross-border groups the problems of
stability and bail-outs were managed by the authorities of the various States, on the principle of
crossborder.
Sharing of the costs of the crisis and the re-nationalization of groups on the verge of insolvency
(Fortis and Dexia). As things now stand, the Colleges of Supervisors (CoS) introduced within the third
level of the Lamfalussy procedure in order to facilitate the coordination between national supervisors
do not have power to manage the rescue of cross-border groups.
Apart from the strengthening of the third level committees, and thus of the CEBS, the proposals
for amendment of the CRD also include the suggestion that the creation of CoS for cross-border groups
should be made compulsory. Furthermore, the liquidity risk management of cross-border groups should
be discussed and coordinated within CoS. This might be a first step towards Europe-wide supervisory
structures, at least with regard to cross-border groups.
Financial Liquidity
Liquidity and Companies
One last understanding of liquidity is especially important for investors: the liquidity of companies that
we may wish to invest in.
Cash is a company's lifeblood. In other words, a company can sell lots of widgets and have good net
earnings, but if it can't collect the actual cash from its customers on a timely basis, it will soon fold up,
unable to pay its own obligations. (To read more, check out The Essentials Of Cash Flow and Spotting
Cash Cows.)
Several ratios look at how easily a company can meet its current obligations. One of these is the current
ratio, which compares the level of current assets to current liabilities. Remember that in this context,
"current" means collectible or payable within one year. Depending on the industry, companies with good
liquidity will usually have a current ratio of more than two. This shows that a company has the resources
on hand to meet its obligations and is less likely to borrow money or enter bankruptcy.
A more stringent measure is the quick ratio, sometimes called the acid test ratio. This uses current assets
(excluding inventory) and compares them to current liabilities. Inventory is removed because, of the
various current assets such as cash, short-term investments or accounts receivable, this is the most
difficult to convert into cash. A value of greater than one is usually considered good from a liquidity
viewpoint, but this is industry dependent.
One last ratio of note is the debt/equity ratio, usually defined as total liabilities divided by stockholders'
equity. While this does not measure a company's liquidity directly, it is related. Generally, companies
with a higher debt/equity ratio will be less liquid, as more of their available cash must be used to service
and reduce the debt. This leaves less cash for other purposes.
Final Words
Liquidity is important for both individuals and companies. While a person may be rich in terms of total
value of assets owned, that person may also end up in trouble if he or she is unable to convert those
assets into cash. The same holds true for companies. Without cash coming in the door, they can quickly
get into trouble with their creditors. Banks are important for both groups, providing financial
intermediation between those who need cash and those who can offer it, thus keeping the cash flowing.
An understanding of the liquidity of a company's stock within the market helps investors judge when to
buy or sell shares. Finally, an understanding of a company's own liquidity helps investors avoid those
that might run into trouble in the near future.
Financial Statement Analysis - Liquidity Ratios
In analyzing Financial Statements for the purpose of granting credit Ratios can be
broadly classified into three categories.
• Liquidity Ratios
• Efficiency Ratios
• Profitability Ratios
Liquidity Ratios:
Liquidity Ratios are ratios that come off the the Balance Sheet and hence measure the
liquidity of the company as on a particular day i.e the day that the Balance Sheet was
prepared. These ratios are important in measuring the ability of a company to meet both
its short term and long term obligations.
FIRST LIQUIDITY RATIO
Current Ratio: This ratio is obtained by dividing the 'Total Current Assets' of a
company by its 'Total Current Liabilities'. The ratio is regarded as a test of liquidity for a
company. It expresses the 'working capital' relationship of current assets available to meet
the company's current obligations.
The formula:
Current Ratio = Total Current Assets/ Total Current Liabilities
An example from our Balance sheet:
Current Ratio = $261,050 / $176,522
Current Ratio = 1.48
The Interpretation:
Lumber & Building Supply Company has $1.48 of Current Assets to meet $1.00 of its
Current Liability
Review the Industry Norms and Ratios for this ratio to compare and see if they are above
below or equal to the others in the same industry.
SECOND LIQUIDITY RATIO
Quick Ratio: This ratio is obtained by dividing the 'Total Quick Assets' of a company by
its 'Total Current Liabilities'. Sometimes a company could be carrying heavy inventory as
part of its current assets, which might be obsolete or slow moving. Thus eliminating
inventory from current assets and then doing the liquidity test is measured by this ratio.
The ratio is regarded as an acid test of liquidity for a company. It expresses the true
'working capital' relationship of its cash, accounts receivables, prepaids and notes
receivables available to meet the company's current obligations.
The formula:
Quick Ratio = Total Quick Assets/ Total Current Liabilities
Quick Assets = Total Current Assets (minus) Inventory
Quick Ratio = $261,050- $156,822 / $176,522
Quick Ratio = $104,228 / $176,522
Quick Ratio = 0.59
The Interpretation:
Lumber & Building Supply Company has $0.59 cents of Quick Assets to meet $1.00 of
its Current Liability
THIRD LIQUIDITY RATIO
Debt to Equity Ratio: This ratio is obtained by dividing the 'Total Liability or Debt ' of a
company by its 'Owners Equity a.k.a Net Worth'. The ratio measures how the company is
leveraging its debt against the capital employed by its owners. If the liabilities exceed the
net worth then in that case the creditors have more stake than the shareowners.
The formula:
Debt to Equity Ratio = Total Liabilities / Owners Equity or Net Worth
Debt to Equity Ratio = $186,522 / $133,522

Debt to Equity Ratio = 1.40
The Interpretation:
Lumber & Building Supply Company has $1.40 cents of Debt and only $1.00 in Equity
to meet this obligation.
Efficiency Ratios:
Efficiency ratios are ratios that come off the the Balance Sheet and the Income Statement
and therefore incorporate one dynamic statement, the income statement and one static
statement , the balance sheet. These ratios are important in measuring the efficiency of a
company in either turning their inventory, sales, assets, accounts receivables or payables.
It also ties into the ability of a company to meet both its short term and long term
obligations. This is because if they do not get paid on time how will you get paid paid on
time. You may have perhaps heard the excuse 'I will pay you when I get paid' or 'My
customers have not paid me!'
FIRST EFFICIENCY RATIO
DSO (Days Sales Outstanding): The Days Sales Outstanding ratio shows both the
average time it takes to turn the receivables into cash and the age, in terms of days, of a
company's accounts receivable. The ratio is regarded as a test of Efficiency for a
company. The effectiveness with which it converts its receivables into cash. This ratio is
of particular importance to credit and collection associates.
Best Possible DSO yields insight into delinquencies since it uses only the current portion
of receivables. As a measurement, the closer the regular DSO is to the Best Possible
DSO, the closer the receivables are to the optimal level.
Best Possible DSO requires three pieces of information for calculation:
• Current Receivables
• Total credit sales for the period analyzed
• The Number of days in the period analyzed
Formula:
Best Possible DSO = Current Receivables/Total Credit Sales X Number of Days
The formula:
Regular DSO = (Total Accounts Receivables/Total Credit Sales) x Number of Days in

the period that is being analyzed
An example from our Balance sheet and Income Statement:
Total Accounts Receivables (from Balance Sheet) = $97,456
Total Credit Sales (from Income Statement) = $727,116
Number of days in the period = 1 year = 360 days ( some take this number as 365 days)
DSO = [ $97,456 / $727,116 ] x 360 = 48.25 days
The Interpretation:
Lumber & Building Supply Company takes approximately 48 days to convert its
accounts receivables into cash. Compare this to their Terms of Net 30 days. This means
at an average their customers take 18 days beyond terms to pay.
SECOND EFFICIENCY RATIO
Inventory Turnover ratio: This ratio is obtained by dividing the 'Total Sales' of a
company by its 'Total Inventory'. The ratio is regarded as a test of Efficiency and
indicates the rapiditity with which the company is able to move its merchandise.
The formula:
Inventory Turnover Ratio = Net Sales / Inventory
It could also be calculated as:
Inventory Turnover Ratio = Cost of Goods Sold / Inventory
Net Sales = $727,116 (from Income Statement)
Total Inventory = $156,822 (from Balance sheet )
Inventory Turnover Ratio = $727,116/ $156,822
Inventory Turnover = 4.6 times

The Interpretation:
Lumber & Building Supply Company is able to rotate its inventory in sales 4.6 times in
one fiscal year.
Review the Industry Norms and Ratios for this ratio to compare their efficiency and see if
they are above, below or equal to the others in the same industry.
THIRD EFFICIENCY RATIO
Accounts Payable to Sales (%): This ratio is obtained by dividing the 'Accounts
Payables' of a company by its 'Annual Net Sales'. This ratio gives you an indication as to
how much of their suppliers money does this company use in order to fund its Sales.
Higher the ratio means that the company is using its suppliers as a source of cheap
financing. The working capital of such companies could be funded by their suppliers..
The formula:
Accounts Payables to Sales Ratio = [Accounts Payables / Net Sales ] x 100
Accounts Payables = $152,240 (from Balance sheet )
Net Sales = $727,116 (from Income Statement)
Accounts Payables to Sales Ratio = [$152,240 / $727,116] x 100
Accounts Payables to Sales Ratio = 20.9%
The Interpretation:
21% of Lumber & Building Supply Company's Sales is being funded by its suppliers.
Profitability Ratios:
Profitability Ratios show how successul a company is in terms of generating returns or

profits on the Investment that it has made in the business. If a business is Liquid and
Efficient it should also be Profitable.
FIRST PROFITIBILITY RATIO
Return on Sales or Profit Margin (%): The Profit Margin of a company determines its
ability to withstand competition and adverse conditions like rising costs, falling prices or
declining sales in the future. The ratio measures the percentage of profits earned per
dollar of sales and thus is a measure of efficiency of the company.
The formula:
Return on Sales or Profit Margin = (Net Profit / Net Sales) x 100
Total Net Profit after Interest and Taxes (from Income Statement) = $5,142
Net Sales (from Income Statement) = $727,116
Return on Sales or Profit Margin = [ $5,142 / $727,116] x 100
Return on Sales or Profit Margin = 0.71%
The Interpretation:
Lumber & Building Supply Company makes 0.71 cents on every $1.00 of Sale
SECOND PROFITABILITY RATIO
Return on Assets: The Return on Assets of a company determines its ability to utitize
the Assets employed in the company efficiently and effectively to earn a good return. The
ratio measures the percentage of profits earned per dollar of Asset and thus is a measure
of efficiency of the company in generating profits on its Assets.
The formula:
Return on Assets = (Net Profit / Total Assets) x 100
Total Assets (from Balance sheet) = $320,044
Return on Assets = [ $5,142 / $320,044] x 100
Return on Assets = 1.60%

The Interpretation:
Lumber & Building Supply Company generates makes 1.60% return on the Assets that it
employs in its operations.
THIRD PROFITABILITY RATIO
Return on Equity or Net Worth: The Return on Equity of a company measures the
ability of the management of the company to generate adequate returns for the capital
invested by the owners of a company. Generally a return of 10% would be desirable to
provide dividents to owners and have funds for future growth of the company
The formula:
Return on Equity or Net Worth = (Net Profit / Net Worth or Owners Equity) x 100
Net Worth or Owners Equity = Total Assets (minus) Total Liability
Net Worth (from Balance sheet) = $133,522
Return on Net Worth = [ $5,142 / $133,522] x 100
Return on Equity or Return on Net Worth = 3.85%
The Interpretation:
Lumber & Building Supply Company generates a 3.85% percent return on the capital
invested by the owners of the company.
Profitability Ratios show how successul a company is in terms of generating returns or

profits on the Investment that it has made in the business. If a business is Liquid and
Efficient it should also be Profitable.
FIRST PROFITIBILITY RATIO
Return on Sales or Profit Margin (%): The Profit Margin of a company determines its
ability to withstand competition and adverse conditions like rising costs, falling prices or
declining sales in the future. The ratio measures the percentage of profits earned per
dollar of sales and thus is a measure of efficiency of the company.
The formula:
Return on Sales or Profit Margin = (Net Profit / Net Sales) x 100
Net Sales (from Income Statement) = $727,116
Return on Sales or Profit Margin = [ $5,142 / $727,116] x 100
Return on Sales or Profit Margin = 0.71%
The Interpretation:
Lumber & Building Supply Company makes 0.71 cents on every $1.00 of Sale
SECOND PROFITABILITY RATIO
Return on Assets: The Return on Assets of a company determines its ability to utitize
the Assets employed in the company efficiently and effectively to earn a good return. The
ratio measures the percentage of profits earned per dollar of Asset and thus is a measure
of efficiency of the company in generating profits on its Assets.
The formula:
Return on Assets = (Net Profit / Total Assets) x 100
Total Assets (from Balance sheet) = $320,044
Return on Assets = [ $5,142 / $320,044] x 100

Return on Assets = 1.60%
The Interpretation:
Lumber & Building Supply Company generates makes 1.60% return on the Assets that it
employs in its operations.
THIRD PROFITABILITY RATIO
Return on Equity or Net Worth: The Return on Equity of a company measures the
ability of the management of the company to generate adequate returns for the capital
invested by the owners of a company. Generally a return of 10% would be desirable to
provide dividents to owners and have funds for future growth of the company
The formula:
Return on Equity or Net Worth = (Net Profit / Net Worth or Owners Equity) x 100
Net Worth or Owners Equity = Total Assets (minus) Total Liability
Net Worth (from Balance sheet) = $133,522
Return on Net Worth = [ $5,142 / $133,522] x 100
Return on Equity or Return on Net Worth = 3.85%
The Interpretation:
Lumber & Building Supply Company generates a 3.85% percent return on the capital
invested by the owners of the company.
Analysis of profitability, liquidity and performance
The profit of a business is the difference between its revenues and its costs. It is
important to consider two main types of profit:
1. Gross profit - this is calculated by deducting the cost of sales of a business from its
sales revenue (turnover).
2. Operating profit - is calculated by then taking away overhead expenses from gross
profit.
Given the above figures it is possible to analyse the profitability of Better Hotels Plc in
the two years. To do this we need to calculate how much of every pound spent by
customers in the hotels is profit. This is calculated in the following way:
1. Gross profit % (i.e. how many pence in each £1 of customer spending is profit). This is
calculated by:
For Better Hotels in 2004 this is:

The profit margin i.e. operating profit % is calculated by:

By examining the profit figures you can see that Better Hotels is more profitable in 2005
than it was in 2004.
Gross profit % has gone up from 60% to 75%, and Operating profit % has increased from
30% to 40%.
Profitability
Using these profitability calculations you are able to compare business profits in one year
compared with others, and also compare the profitability of different businesses.
Another important measure of how well a business is being run is how liquid it is. To do
this you need to look at the current assets and current liabilities in the balance sheet.
The following shows part of the balance sheet for Better Hotels in 2004 and 2005:
Extract from Balance Sheet 31st Dec 2004 by examining the two balance sheets it is
possible to see that in 2005, Better Hotels has a more liquid assets relative to current
liabilities.
In 2004 the ratio of current assets to current liabilities was:

80:40 (i.e. £2 for every £1)
In 2005 the ratio was:

90:40 (i.e. £2.50 for every £1)
It is important for businesses to have a good liquidity position because, should people
that the business owes money to (current liabilities) press for payment it is essential to
have the liquidity to pay up. A liquid asset is one that can quickly be turned into cash.
Working capital
We use the term working capital to describe the difference between current assets and
current liabilities. A business has working capital if its current assets are greater than its
current liabilities. Working capital is required for the day-to-day running of a business -
paying bills, wages etc.
A business performs well when it has:

*high and rising sales
*high and rising profits
*good control over its costs
*a good liquidity/working capital position.
Liquidity-profitability tradeoff
INTRODUCTION
Efficient liquidity management involves planning and controlling currant assets and
currant liabilities in such a manner that eliminates the risk of the inability to meet due
short-term obligations, on one hand, and avoids excessive investment in these assets, on
the other. This is due in part to the reduction of the probability of running out of cash in
the presence of liquid assets.
The working capital approach to liquidity management has long been the prominent
technique used to plan and control liquidity. The working capital includes all the items
shown on a company's balance sheet as short-term or current assets, while net working
capital excludes current liabilities. This measure is considered a useful tool in accessing
the availability of funds to meet current operations of companies. However, instead of
using working capital as a measure of liquidity, many analysts advocate the use of currant
and quick ratios, which have the advantage of making temporal or cross sectional
comparison possible.
However, the ultimate measure of the efficiency of liquidity planning and control is the
effect it has on profits and shareholders' value. Thus, this study attempts to examine the
relation between liquidity and profitability using a sample of Saudi joint stock
companies. Second, the study aims at directing the attention to the importance of active
management of liquidity. This aspect is more important given the number of non-
profitable Saudi companies, and the dire need to improve profitability.
To carry out these objectives the remainder of this paper is organized as follows: the next
section reviews the literature for relevant theoretical and empirical work on liquidity and
cash management and its effect on profitability. Section three describes the sample and
the methodology followed in this study. Section four portrays and discusses the statistical
results, while section five explores the implications of the study. The final section,
section six, concludes the paper.
LITERATURE REVIEW
Working capital represents a safety cushion for providers of short-term funds of the
company, and as such they view positively the availability of excessive levels of working
capital and cash. However, from an operating point of view, working capital has
increasingly been looked at as a restraint on financial performance, since these assets do
not contribute to return on equity (Sanger, 2001). Furthermore, liquidity management is
important in good times and it takes further importance in troubled times. The efficient
management of the broader measure of liquidity, working capital, and its narrower
measure, cash, are both important for a company's profitability and well being. In the
words of Fraser (1998) "there may be no more financial discipline that is more important,
more misunderstood, and more often overlooked than cash management." However, as
argued vividly by Nicholas (1991,) companies usually do not think about improving
liquidity management before reaching crisis conditions or becoming on the verge of
bankruptcy.
Survey of working capital and cash management literature, however, shows that instead
of linking liquidity and cash management to a known efficiency or profitability measures,
the majority of research, especially the earlier efforts, attempts to develop models for
optimal liquidity and cash balances, given the organization's cash flows. The earlier cash
management research focused on using quantitative models that weight the benefits and
costs of holding cash (liquidity). Under this category falls Baumol's (1952) inventory
management model and Miller and Orr's (1966) model which recognizes the dynamics of
cash flows. The benefit of these earlier models is that they help financial managers
understand the problem of cash management, but they do require assumptions that may
not hold in practice.
Similarly, Johnson and Aggarwal (1988) support a treasury approach to cash

management, which concentrates on flows which entail that cash collection and payment
cycles must be broken into their constituent parts. Management then should review the
time needed for each link in the collection and payment cycles. Some policy outlines,
similar to these, were proposed by Schneider (1988) by arguing that cash management
should include analytical review of the procedures followed in managing working capital.
These include granting of credit, managing balances, and collecting payments when due.
The subsequent and more practical approaches to liquidity management focused on

working capital requirements and levels of desired liquidity as measured by current ratio
and its variants. The finance textbooks and literature covered the techniques and
approaches aimed at managing working capital and its individual components. Again
most of these approaches attempt to develop an optimal level of working capital
components under certain assumptions, albeit less restrictive than their earlier
counterparts used to facilitate development of cash management techniques.
Various other techniques have been suggested to improve liquidity and cash positions and
to increase the efficiency of their management and in turn profitability. These include
credit insurance (Brealey and Myers, 1996; Unsworth, 2000; and Raspanti, 2000),
factoring of receivables (Brealey and Myers, 1996; Summers and Wilson, 2000).
However, as measures of liquidity, both the working capital and liquidity ratios have
tome under criticism for various reasons. Hawawini et al. (1986), for example, argue that
the concept of working capital requirement is a better measure of a firm's investment in
its operating cycle than the traditional concept of net working capital. Similarly, Finnerty
(1993) points out that the traditional liquidity ratios, such as the current ratio or quick
ratio, include both liquid financial assets and operating assets in their formula. Thus, from
an ongoing concern point of view, the inclusion of operating assets which are tied up in
operations is not useful. Kamath (1989), however, argues that both current and quick
ratios are deficient due to their static nature and the inadequacy of using them as
measures of future cash flows and liquidity.
These shortcomings of working capital and liquidity ratios have led researchers and
analysts to advocate other measures of liquidity that are more indicative of cash
availability. The net cash conversion cycle, or the cash gap has been suggested by many
as a possible supplement or replacement to the working capital and current ratios as
measures of available liquidity (see Gitman (1974), Richard and Laughlin (1980), Boer
(1999), and Gentry et al., (1990).
It is generally argued that this approach is more practical due to the dynamic nature of
cash cycles and the many complications and tradeoffs involved. Some authors, such as
Kamath (1989), suggest that cash gaps can be used to replace or supplement liquidity
ratios (current ratio and quick ratio) in measuring and predicting the nature and pattern of
future cash flows. The static current ratios alone fall short of adequately predicting future
cash flows. Other studies, such as Kolay (1991), differentiate between short-term and
long-term strategies that improve financial position and cash management policies.
The cash gap, known also as cash flow cycle or cash conversion cycle, measures the
length of time between actual cash expenditures on productive resources and actual cash
receipts from the sale of products or services. Thus, this definition for cash conversion
cycle indicates that a shorter cash cycle or gap is desirable since the larger the cash cycle
or gap the greater the need for external financing and the greater the financing costs to be
borne in form of explicit interest costs or implicit costs of other financing sources, such
as equity. The interest cost is more expensive in Saudi Arabia, than in other countries,
because of the absence of tax savings (national companies incorporated in Saudi Arabia
are not required to pay taxes, they instead pay zakat (level or fixed percentage tax
required by Islamic sharia).
To emphasize the importance of managing liquidity, Loeser (1988) tapped the extreme in
order to reduce the cash cycle. Loeser recommended assessing interest charge at the
prime rate to outstanding accounts receivable and unbilled revenue in order to encourage
responsible employees and departments within companies to put every effort necessary to
collect receivables, and thus reduce cash gaps. This same approach was expressed
recently by Fraser (1998) who argues that liquidity and cash gap management starts with
a simple task for financial managers by making certain that their billings, collections, and
payables systems are operating efficiently.
The direct effect of liquidity is not only on the cash position and the troubles it may cause
to financial managers, but it rather effects the company's profits in a more direct way.
This direct effect stems from the need of the company to borrow to finance the working
capital requirements and cash gaps. For example, if a company has a cash gap of 100
days, this means that the company has to borrow an amount equivalent to 100 times the
daily cost of sales. The borrowing cost reduces both pretax and after-tax profits by equal
amounts. In Saudi Arabia the feature of borrowing cost as a cheap source of financing
loses its tax advantage since there is no tax on Saudi companies' profits. Likewise,
reducing cash gaps by any number of days will add equally to the pretax and after-tax
profits.
Shin and Soenen (1998) investigated the relation between the firm's net trade cycle and
its profitability, using a large sample of American firms during 1975-1994. The study
found a strong negative relation between the length of the firm's net trade cycle and
various measures of profitability, including market measures, such as stock returns, and
operating profits. Similarly, this study attempts to examine the relationship between
operating profitability and liquidity measures. Unlike previous studies, an attempt is
made here to study the effects of various levels of liquidity, in its broader or narrow
sense, on a company's profitability.
DATA AND METHODOLOGY
Since the aim of this study is to examine the relation between profitability and liquidity,
the study makes a set of testable hypotheses. First, this study assumes that there may be a
relationship between profitability of the company and its liquidity profile, since the later
effects the former in a direct way, as a result of the external financing costs or savings
thereof. Due to these elements of costs and cost savings this relationship is most likely be
negative. Thus, the first hypothesis of this study can be stated as follows:
Hypothesis 1
There is a possible negative relation between liquidity of a company and its profitability.
Companies with relatively high levels of liquidity are expected to post low levels of
profitability and vise versa.
Secondly, profitability, on the other hand, may be a function of the size of companies
(measured in terms of sales or total assets). The company size may affect liquidity, cash
gaps and, hence, profitability in different ways. On the one hand, large companies may be
able to buy inventory in large quantities in order to get quantity discounts. Further,
because of their size, large companies may qualify for quantity discounts from suppliers
with relatively small inventory levels. On the other hand, large companies may be able to
get favorable credit terms from their suppliers in terms of longer credit periods.
Moreover, large companies may have more success in their receivables collection efforts
relative to small companies. All these factors may push liquidity levels and cash gaps of
large companies to levels lower than that of small companies. On the contrary, small
companies are usually not able to obtain as much inventory to qualify for quantity
discounts as their large counterparts do. Additionally, small companies make efforts to
pay within discount periods in order to benefit from cash discounts and to avoid severing
their relations with their suppliers. These factors may force small companies to have
higher liquidity levels and larger cash gaps. Accordingly, this study states the following
hypothesis:
Hypothesis 2:
A positive relation may exist between the company size and its profitability. This may be
due to the ability of large companies to reduce liquidity levels and cash gaps.
Third, liquidity and cash gaps may differ among industries and among countries and may
depend on the prevailing economic conditions. Sometimes traditions and the nature of
business set the typical working capital requirements and the cash gap in a given
industry. Some industries have inherently high levels of working capital requirements and
large cash gaps than others, while some may require low levels of working capital and
shorter or even negative cash gaps, which indicate their ability to obtain cost-free capital
from their customers. Hawawini et al. (1986) examined a sample of 1181 American firms
from thirty-six industries over a period of nineteen years and found significant and
persistent industry effects on a firm's investment in working capital. The ability to
operate with low levels of working capital and obtaining cost-free capital may have direct
positive bearing on profitability. Thus, this study states the following hypothesis:
Hypothesis 3:
Need for working capital and liquidity is influenced by the industry in which the
company operates. Capital intensive industries require low levels of working capital and
tend to have smaller cash gaps than their labor-intensive counterparts. Accordingly,
liquidity requirement is expected to have no significant negative impact on profitability
of capital--intensive industries, while such effect is expected in labor- intensive ones.
To test these hypotheses this study uses the following methodology:
1. The study first estimates the cash gap for each company and for each year of the
sample period as follows:
Cash Gap = Days in Inventory (DII) + Days in Accounts Receivable (DIR)--Days in

Accounts Payable (DIP)
The components of the cash gap are calculated as follows:
--Inventory turnover = cost of goods sold/average inventory
--Number of days in inventory = 365/inventory turnover
--Number of days in Receivables = Receivables/average daily sales
--Number of days in Payables = Payables / average daily purchases

2. Correlation analysis to identify the association between profitability and liquidity
indicators and other related variables
3. Regression analysis to estimate the causal relationship between profitability variable,

liquidity and other chosen variables
The data for this study comes from a sample of Saudi joint stock companies. Overall, 29
joint stock companies that are publicly traded and provide annual audited financial
reports are selected. This sample encompasses three basic Saudi economic sectors. Table
1 shows the sample by sector over the period 1996-2000. However, due to unavailability
of data in some of the years for some companies and sectors, the distribution of the
sample is not homogenous over the sample period.
The sample does not include electricity and banking sector companies. The former is
regulated and has undergone major structural changes during the sample period, while the
banking sector activity does not fit the issues at hand. It should be mentioned that some
problems are encountered in collecting the data for this study. First, most cement
companies in the Kingdom do not disclose sales revenue. Second, most companies do not
report the purchases figure or detailed cost of goods sold figures. Thus, the sample is
restricted to those companies for which purchases figure can be calculated and the sales
figures are available. Both components are necessary to calculate cash gaps.
Nevertheless, the total sample represents about 50 percent of the total number of Saudi
publicly held companies (excluding Banking and electricity companies). Thus, the final
sample includes the most important joint stock companies in Saudi Arabia .
RESULTS AND ANALYSIS
The following notations are used throughout this study:
S= net sales
TA= Total assets
CG= Cash gap in days
CR= Current ratio
LOGS= Logarithm...
Reliance Industries Limted
Public
Type BSE: 500325
LSE: RIGD
Industry Conglomerate
1966 As Reliance Commercial
Founded
Corporation
Founder(s) Dhirubhai Ambani
Headquarters Mumbai, Maharashtra, India
Area served Worldwide
Mukesh Ambani
Key people
(Chairman & MD)
Products Petroleum
Natural gas
Petrochemicals
Retail stores
Polymers
Polyesters
Chemicals
Textile
Telecommunications
203,740.00 crore (US$44.21
Revenue
billion) (2010)
Operating 28,680.00 crore (US$6.22 billion)
income (2010)
15,818.00 crore (US$3.43 billion)
Net income
(2010)
245,706 crore (US$53.32 billion)
Total assets
(2009)
146,328 crore (US$31.75 billion)
Total equity
(2009)
Employees 24,679 (2009)
Reliance Petroleum
Reliance Life Sciences
Reliance Industrial Infrastructure
Limited
Reliance Institute of Life Sciences
Subsidiaries Reliance Logistics
Reliance Clinical Research
Services
Reliance Solar
Relicord
Infotel Broadband
Website RIL.com
Reliance Industries Limited (BSE: 500325, LSE: RIGD) is India's largest private sector
conglomerate company by market value, with an annual turnover of US$ 44.6 billion and
profit of US$ 3.6 billion for the fiscal year ending in March 2010 making it one of the
largest India's private sector companies, being ranked at 264th position in the Fortune
Global 500 (2009) and at the 126th position in the Forbes Global 2000 list (2010).
Reliance was founded by the Indian industrialist Dhirubhai Ambani in 1966. Ambani has
been a pioneer in introducing financial instruments like fully convertible debentures to
the Indian stock markets. Ambani was one of the first entrepreneurs to draw retail
investors to the stock markets. Critics allege that the rise of Reliance Industries to the top
slot in terms of market capitalization is largely due to Dhirubhai's ability to manipulate
the levers of a controlled economy to his advantage.
Though the company's oil-related operations form the core of its business, it has
diversified its operations in recent years. After severe differences between the founder's
two sons, Mukesh Ambani and Anil Ambani, the group was divided between them in
2006. In September 2008, Reliance Industries was the only Indian firm featured in the
Forbes's list of "world's 100 most respected companies".
Stock
According to the company website "1 out of every 4 investors in India is a Reliance
shareholder.". Reliance has more than 3 million shareholders, making it one of the
world's most widely held stock. Reliance Industries Ltd, subsequent to its split in January
2006 has continued to grow. Reliance companies have been among the best performing in
the Indian stock market.
Products
Reliance Industries Limited has a wide range of products from petroleum products,
petrochemicals, to garments (under the brand name of Vimal), Reliance Retail has
entered into the fresh foods market as Reliance Fresh and launched a non-veg chain
called Delight Reliance Retail and NOVA Chemicals have signed a letter of intent to
make energy-efficient structures.
The primary business of the company is petroleum refining and petrochemicals. It

operates a 33 million tonne refinery at Jamnagar in the Indian state of Gujarat. Reliance
has also completed a second refinery of 29 million tons at the same site which started
operations in December 2008. The company is also involved in oil & gas exploration and
production. In 2002, it struck a major find on India's eastern coast in the Krishna
Godavari basin. Gas production from this find was started on 2 April 2009. As of the end
of 3rd quarter of 2009-2010, gas production from the KG D6 ramped up to 60
MMSCMD.
Businesses
Major subsidiaries and associates
• Reliance Petroleum Limited (RPL) was a subsidiary of Reliance Industries

Limited (RIL) and was created to exploit the emerging opportunities, creating
value in the refining sector worldwide.Currently, RPL stands amalgamated with
RIL.
• Reliance Life Sciences is a research-driven, biotechnology-led, life sciences

organization that participates in medical, plant and industrial biotechnology
opportunities. Specifically, these relate to Biopharmaceuticals, Pharmaceuticals,
Clinical Research Services, Regenerative Medicine, Molecular Medicine, Novel
Therapeutics, Biofuels, Plant Biotechnology and Industrial Biotechnology.
• Reliance Industrial Infrastructure Limited (RIIL) is engaged in the business of

setting up / operating Industrial Infrastructure that also involves leasing and
providing services connected with computer software and data processing.
• Reliance Institute of Life Sciences (Rils), established by Dhirubhai Ambani

Foundation, is an institution of higher education in various fields of life sciences
and related technologies.
• Reliance Logistics (P) Limited is a single window solutions provider for

transportation, distribution, warehousing, logistics, and supply chain needs,
supported by in house state of art telematics and telemetry solutions.
• Reliance Clinical Research Services (RCRS), a contract research organization

(CRO) and wholly owned subsidiary of Reliance Life Sciences, has been set up
to provide clinical research services to pharmaceutical, biotechnology and
medical device companies.
• Reliance Solar, The solar energy initiative of Reliance aims to bring solar
energy systems and solutions primarily to remote and rural areas and bring
about a transformation in the quality of life.
• Relicord is the first and one of the most dependable stem-cell banking services
of South East Asia offered by Mukesh Ambani controlled by Reliance
Industries.
• Infotel Broadband is a broadband service provider, it is wholly owned by RIL

for 4,800 crore.
Oil and gas discovery
In 2002, Reliance found natural gas in the Krishna Godavari basin off the coast of
Andhra Pradesh near Vishakapatnam.[15] It was the largest discovery of natural gas in
world in financial year 2002-2003.[16] On 2 April 2009, Reliance Industries (RIL)
commenced natural gas production from its D-6 block in the Krishna-Godavari (KG)
basin.
The gas reserve is 7 trillion cubic feet in size. Equivalent to 1.2 billion barrels (165
million tonnes) of crude oil, but only 5 trillion cubic feet are extractable.
On 2008 Oct 8, Anil Ambani's Reliance Natural Resources took Reliance Industries to
the Bombay High Court to uphold a memorandum of understanding that said RIL will
supply the natural gas at $2.34 per million British thermal units to Anil Ambani.
Reliance retail
Reliance Retail is the retail business wing of the Reliance business. Many brands like
Reliance Fresh, Reliance Footprint, Reliance Time Out, Reliance Digital, Reliance
Wellness, Reliance Trendz, Reliance Autozone, Reliance Super, Reliance Mart, Reliance
iStore, Reliance Home Kitchens, and Reliance Jewel come under the Reliance Retail
brand.
Environmental record
Reliance Industry is the worlds largest polyester producer and as a result one of the
largest producers of polyester waste in the world. In order to deal with this large amount
of waste they had to create a way to recycle the waste. They operate the largest polyester
recycling center that uses the polyester waste as a filling and stuffing. They use this
process to develop a strong recycling process which won them a reward in the Team
Excellence competition.
Reliance Industries backed a conference on environmental awareness in New Delhi in

2006. The conference was run by the Asia Pacific Jurist Association in partnership with
the Ministry of Environment & Forests, Govt. of India and the Maharashtra Pollution
Control Board. The conference was to help bring about new ideas and articles on various
aspects of environmental protection in the region. Maharashtra Pollution Control Board
invited various industries complied with the pollution control norms to take active part in
the conference and to support as a sponsor. The conference proved effective as a way to
promote environmental concern in the area.
Awards and recognition
• International Refiner of the Year in 2005 at the 23rd Annual Hart's World
Refining and Fuels Conference .
Awards for managers
• Mukesh D. Ambani received the United States of America-India Business

Council (USIBC) leadership award for "Global Vision" 2007 in Washington in
July 2007.
• Mukesh D. Ambani was conferred the Asia Society Leadership Award by the
Asia Society, Washington, USA, May 2004.
• Mukesh D. Ambani ranked 13th in Asia's Power 25 list of The Most Powerful
People in Business published by Fortune magazine, August 2004.
• Mukesh D. Ambani is Economic Times Business Leader of the Year
• Mukesh Ambani was ranked as the 74th Most Trusted Individual in India in an
early 2010 survey conducted by the Indian edition of Readers' Digest magazine.
Company Information
36th Annual General Meeting on Friday, June 18, 2010 at 11.00 a.m.
at Birla Matushri Sabhagar, 19, Marine Lines, Mumbai 400 020.
Board of Directors
Finance Committee
Mukesh D. Ambani
(Chairman)
Nikhil R. Meswani
Hital R. Meswani
Health, Safety &
Environment Committee
Hital R. Meswani
Dr. Dharam Vir Kapur
Pawan Kumar Kapil
Remuneration Committee
Mansingh L. Bhakta
(Chairman)
Yogendra P. Trivedi
Shareholders’/Investors’
Grievance Committee
Mansingh L. Bhakta
(Chairman)
Yogendra P. Trivedi
Nikhil R. Meswani
Hital R. Meswani
Audit Committee
Yogendra P. Trivedi
(Chairman)
Mahesh P. Modi
Dr. Raghunath A.
Mashelkar
Corporate Governance
and Stakeholders’
Interface Committee
Yogendra P. Trivedi
(Chairman)
Mahesh P. Modi
Employees Stock
Compensation Committee
Yogendra P. Trivedi
(Chairman)
Mukesh D. Ambani
Mahesh P. Modi
Prof. Dipak C. Jain
Board Committees
Company Secretary Vinod M. Ambani
Solicitors & Advocates Kanga & Co.
Auditors Chaturvedi & Shah,
Deloitte Haskins & Sells
Rajendra & Co.
Chairman & Managing Director
Mukesh D. Ambani
Executive Directors
Nikhil R. Meswani
Hital R. Meswani
Hardev Singh Kohli1
P.M.S. Prasad2
R Ravimohan3
Pawan Kumar Kapil4
Non Executive Directors
Ramniklal H. Ambani
Mansingh L. Bhakta
Yogendra P. Trivedi
Mahesh P. Modi
S. Venkitaramanan5
Prof. Ashok Misra
Prof. Dipak C. Jain
Dr. Raghunath A. Mashelkar
Bankers
ABN Amro
Allahabad Bank
Andhra Bank
Bank of America
Bank of Baroda
Bank of India
Bank of Maharashtra
Calyon Bank
Canara Bank
Central Bank of India
Citibank N.A
Corporation Bank
Deutsche Bank
The Hong Kong and
Shanghai Banking
Corporation Limited
HDFC Bank Limited
ICICI Bank Limited
IDBI Bank Limited
Indian Bank
Indian Overseas Bank
Oriental Bank of
Commerce
Punjab National Bank
Standard Chartered Bank
State Bank of Hyderabad
State Bank of India
State Bank of Patiala
Syndicate Bank
Union Bank of India
Vijaya Bank
Major Plant Locations
Dahej
P. O. Dahej,
Bharuch - 392 130
Gujarat, India
Gadimoga
Tallarevu Mandal
East Godavari District
Gadimoga – 533 463
Andhra Pradesh, India
Hazira
Village Mora, Bhatha
P.O.Surat-Hazira Road
Surat 394 510,
Gujarat, India
Jamnagar
Village Meghpar / Padana,
Taluka Lalpur
Jamnagar 361 280
Gujarat, India
Jamnagar SEZ
Village Meghpar / Padana,
Taluka Lalpur
Jamnagar 361 280
Gujarat, India
Nagothane
P. O. Petrochemicals
Township, Nagothane
Raigad - 402 125,
Maharashtra, India
Patalganga
B-4, Industrial Area,
Patalganga, Near Panvel,
Dist. Raigad 410 207
Maharashtra, India
Vadodara
P. O. Petrochemicals
Vadodara - 391 346,
Gujarat, India
Registrars & Transfer Agents
Karvy Computershare Private Limited, 46, Avenue 4,
Street No.1, Banjara Hills, Hyderabad 500 034, India
Tel: +91 40 2332 0666, 2332 0711, 2332 3031, 2332 3037
Toll Free No. 1800 425 8998 Fax: +91 40 2332 3058
e-mail: [email protected] Website : www.karvy.com
Registered Office
3rd Floor, Maker Chambers IV
222 Nariman Point, Mumbai 400 021, India
Tel: +91 22 2278 5000 Fax: +91 22 2278 5111
e-mail: [email protected]
Website : www.ril.com
1upto March 31, 2010
2w.e.f. August 21, 2009
3from September 1, 2009 to December 28, 2009
4w.e.f. May 16, 2010
5upto July 24, 2009
Think Growth. Think Transformation. Think Reliance. 8
Reliance Industries Limited 9

Financial Highlights
Key Indicators
2009-10 08-09 07-08 06-07 05-06 04-05 03-04 02-03 01-02
00-01
Earnings Per Share - Rs.* 1.1 49.7 49.7 105.3 82.2 65.1 54.2 36.8 29.3 20.6
25.1
[excluding Exceptional item]
Turnover Per Share - Rs.* 13.7 612.9 464.9 958.1 814.2 639.6 525.0 402.8 358.8
325.2 218.5
Book Value Per Share - Rs.* 9.3 419.5 401.5 560.3 440.0 357.4 289.9 246.7 217.2 199.2
140.1
Debt : Equity Ratio 0.46:1 0.63:1 0.45:1 0.44:1 0.44:1 0.46:1 0.56:1 0.60:1
0.64:1 0.72:1
EBDIT / Gross Turnover % 16.5 16.5 17.3 20.8 17.3 16.8 19.5 19.5 18.7 19.1 26.8
Net Profit Margin % 8.1 8.1 10.5 14.0 10.1 10.2 10.3 9.2 8.2 7.1 12.8
RONW % ** 16.4 16.4 21.6 28.8 23.5 22.7 21.9 17.0 14.8 16.1 20.0
ROCE % ** 13.9 13.9 20.3 20.3 20.5 20.5 21.3 14.0 13.2 15.3 20.4
$
Rs. in crore
2009-10 08-09 07-08 06-07 05-06 04-05 03-04 02-03 01-02 00-01
$ Mn
Turnover 44,632 200,400 146,328 139,269 118,354 89,124 73,164 56,247 50,096 45,404
23,024
Total Income 45,180 202,860 148,388 144,898 118,832 89,807 74,614 57,385 51,097
46,186 23,407
Earnings Before Depreciation, 7,359 33,041 25,374 28,935 20,525 14,982 14,261
10,983 9,366 8,658 5,562
Interest and Tax (EBDIT)
Depreciation 2,338 10,497 5,195 4,847 4,815 3,401 3,724 3,247 2,837 2,816 1,565
Exceptional Items - - (370) 4,733 - - - - - 412 -
Profit After Tax 3,616 16,236 15,309 19,458 11,943 9,069 7,572 5,160 4,104 3,243
2,646
Equity Dividend %* 70 130 130 110 100 75 52.5 50 47.5 42.5
Dividend Payout 464 2,084 1,897 1,631 1,440 1,393 1,045 733 698 663 448
Equity Share Capital 728 3,270 1,574 1,454 1,393 1,393 1,393 1,396 1,396 1,054 1,053
Equity Share Suspense Account - - 69 - 60 - - - - 342 -
Equity Share Warrants - - - 1,682 - - - - - - -
Reserves and Surplus 29,822 133,901 124,730 78,313 62,514 48,411 39,010 33,057
28,931 26,416 13,712
Net Worth 30,550 137,171 126,373 81,449 63,967 49,804 40,403 34,453 30,327 27,812
14,765
Gross Fixed Assets 50,780 228,004 218,673 127,235 107,061 91,928 59,955 56,860
52,547 48,261 25,868
Net Fixed Assets 36,837 165,399 169,387 84,889 71,189 62,675 35,082 35,146 34,086
33,184 14,027
Total Assets 55,903 251,006 245,706 149,792 117,353 93,095 80,586 71,157 63,737
56,485 29,875
Market Capitalisation 78,245 351,320 239,721 329,179 198,905 110,958 76,079 75,132
38,603 41,989 41,191
Number of Employees 23,365 24,679 25,487 24,696 12,540 12,113 11,358 12,915
12,864 15,083
Contribution to National 4,003 17,972 11,574 13,696 15,344 15,950 13,972 12,903
13,210 10,470 4,277
Exchequer
In this Annual Report $ denotes US$
1US$ = Rs. 44.90 (Exchange rate as on 31.03.2010)
* After consideration of issue of bonus shares in 2009-10 in the ratio of 1:1
** Adjusted for CWIP and revaluation

Financial Health in Terms of Profitabilty and Liquidity

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Financial Health in Terms of Profitabilty and Liquidity

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Business

FINANCIAL HEALTH IN TERMS OF

PROFITABILTY AND LIQUIDITY

You may be a great performer, but...

Competitive Advantages & Disadvantages

Budgeting & Forecasting

Measuring Financial Health

Financial Crisis and New Dimensions of Liquidity

2. Definition and Evolution of the Concept of Liquidity

The Lessons for Financial Regulation and Supervision

Liquidity Risk: Beyond Basel 2

Market Liquidity Risk

The monetary authorities’ intervention has focused on a widening of collaterals, an extension of

Liquidity and Companies

FIRST LIQUIDITY RATIO

Current Ratio = Total Current Assets/ Total Current Liabilities

An example from our Balance sheet:

Current Ratio = $261,050 / $176,522

Current Ratio = 1.48

Quick Ratio = Total Quick Assets/ Total Current Liabilities

Quick Assets = Total Current Assets (minus) Inventory

An example from our Balance sheet:

Quick Ratio = $261,050- $156,822 / $176,522

Quick Ratio = $104,228 / $176,522

Quick Ratio = 0.59

THIRD LIQUIDITY RATIO

Debt to Equity Ratio = Total Liabilities / Owners Equity or Net Worth

An example from our Balance sheet:

Debt to Equity Ratio = $186,522 / $133,522

FIRST EFFICIENCY RATIO

Best Possible DSO = Current Receivables/Total Credit Sales X Number of Days

Regular DSO = (Total Accounts Receivables/Total Credit Sales) x Number of Days in

Total Accounts Receivables (from Balance Sheet) = $97,456

Total Credit Sales (from Income Statement) = $727,116

DSO = [ $97,456 / $727,116 ] x 360 = 48.25 days

SECOND EFFICIENCY RATIO

Inventory Turnover Ratio = Net Sales / Inventory

It could also be calculated as:

Inventory Turnover Ratio = Cost of Goods Sold / Inventory

An example from our Balance sheet and Income Statement:

Net Sales = $727,116 (from Income Statement)

Total Inventory = $156,822 (from Balance sheet )

Inventory Turnover Ratio = $727,116/ $156,822

Inventory Turnover = 4.6 times

THIRD EFFICIENCY RATIO

Accounts Payables to Sales Ratio = [Accounts Payables / Net Sales ] x 100

An example from our Balance sheet and Income Statement:

Accounts Payables = $152,240 (from Balance sheet )

Net Sales = $727,116 (from Income Statement)

Accounts Payables to Sales Ratio = [$152,240 / $727,116] x 100

Accounts Payables to Sales Ratio = 20.9%

Profitability Ratios show how successul a company is in terms of generating returns or

FIRST PROFITIBILITY RATIO

Return on Sales or Profit Margin = (Net Profit / Net Sales) x 100

An example from our Balance sheet and Income Statement:

Net Sales (from Income Statement) = $727,116

Return on Sales or Profit Margin = [ $5,142 / $727,116] x 100

Return on Sales or Profit Margin = 0.71%

SECOND PROFITABILITY RATIO