This part will highlight two distinct accounting aspects which are crucial to a firm's viability and profitability: liquidity and solvency (Colquitt, 2007, p.145). On one hand, the concept of liquidity 'refers to the ability of a business to turn its assets into cash as and when creditors need paying' (Lewis et al., 2000, p.612). Basically, liquidity deals with short term periods. On the other hand, the term solvency also 'refers to the ability of a business to pay its creditors' (Lewis et al., 2000, p.612). But it corresponds to the ability to satisfy cash obligations on a long term perspective (Schuppe, 1993, p.44). A business will be qualified as insolvent if the assets are lower than the liabilities. Through this context, the following part will consider these two concepts for Woolworths' company, supported by different ratios' calculations.
Liquidity
As introduced above, liquidity matches with the capability of companies to deal with short term cash requirements (Bernstein et al., 2000, p.112). Three ratios have to be pointed out in order to represent the degree of liquidity of a company: the current ratio, the quick ratio and the cash flow from operations to current liabilities (Stickney et al., 2007, p.273). Based on the financial report of Woolworths, we calculated these different ratios for the last three years.
The grid below corresponds to the calculation of the current ratio obtained through the division of the current assets by the current liabilities:
Woolworths
2008
2007
2006
Current Assets
4502.20
4161.00
4120.80
Current Liabilities
6424.40
5502.80
4874.30
Current Ratio
0.70
0.76
0.85
Regarding the debt-paying ability, 'the higher the current ratio, the better' (Marshall et al., 2007, p.79). However, the Woolworths' current ratios for the three last years are below 1 which highlights a low degree of liquidity. Indeed, a current ratio below 1 implies that Woolworth has more obligations coming during the following year than 'assets it can expect to turn cash' (Damodoran, 2002, p.48). However, it is argued that interpretation of ratios should vary regarding the industry (Bradshaw et al, 2007, p.116). In this context, we have considered the ratios of a direct competitor named Wesfarmers.
Wesfarmers
2008
2007
2006
Current Assets
8676.00
4024.00
3133.59
Current Liabilities
7940.00
7182.00
2578.00
Current Ratio
1.09
0.56
1.22
Although irregularities appear in the numbers following the years, Wesfarmers' current ratio display better results than Woolworths supporting the fact that Woolworths encounter liquidity issues.
Below, figures the quick ratio that corresponds to the same calculation as the current ratio except that the inventories are deducted from the current assets. This emphasizes the short term perspective implied by the liquidity of a business since inventories tend to take a long time to be converted into cash (Tracy, 2009, p.130)
Woolworths
2008
2007
2006
Cash + marketable securities +
accounts receivable
1492.20
1421.80
1804.70
Current Liabilities
6424.40
5502.80
4874.30
Quick Ratio
0.23
0.26
0.37
In the same way as the current ratios, the quick ratios display poor results suggesting a low degree of liquidity from Woolworths.
The last ratio which is relevant with regards to liquidity corresponds to the cash flow from operations to current liabilities. This ratio actually 'measures the cash available to pay current obligations' (Bernstein et al., 2000, p.129). By considering the cash flow for the year in the numerator and the average current liabilities in the denominator, this ratio 'overcomes' the deficiencies implied by the current or the quick ratio (Stickney et al., 2007, p.267). Indeed, they may not represent 'normal conditions' since they deal with amounts at a specific time.
Woolworths
2008
2007
2006
Cash flow from operations
2654.00
2294.20
1704.80
Average current Liabilities
5963.60
5188.55
4327.45
Cash flow from operations to
current liabilities ratio
0.45
0.44
0.39
Some analysts point out that a healthy firm should meet a result of 40% or more to be considered healthy (Stickney et al., 2007, p.267) which is the case of Woolworths.
Solvency
Several ratios measure long term liquidity risk, giving an overview of the solvency of a company. We will consider three of them: the debt to equity ratio, the cash flow from operations to total liabilities and the interest coverage ratio (Stickney et al., 2007, p.273). Through the same way as liquidity, we calculated these different ratios based on the Woolworths' financial reports of the last three years.
The debt to equity ratio shows the long-term stability of a company measuring the risk of insolvency. The following result implies that for every one dollar of owner's equity, Woolworths has 1,513 AUD of borrowings (Lara, 2005).
Woolworths
2008
2007
2006
Total Liabilities
9437.20
8901.40
9088.80
Total Equity
6235.30
5514.70
4257.60
Debt to equity ratio
151.35%
161.41%
213.47%
In comparison to Woolworths, Wesfarmers display irregular results regarding the last three years. However, it displayed a significant better debt to equity ratio in 2008 with a result of 90%.
Wesfarmers
2008
2007
2006
Total Liabilities
17716.00
8573.00
4349.00
Total Equity
19590.00
3503.00
3166.00
Debt to equity ratio
90.43%
244.73%
137.37%
Therefore, although Woolworths has considerably improved its solvency since 2006, it must strive to keep focusing on its efforts to get a better debt to equity ratio.
The cash flow from operations to total liabilities ratio indicates 'the business's ability to pay off its total liabilities from its normal operating cash flow' (Bradshaw, 2007, p.117).
Woolworths
2008
2007
2006
Cash flow from operations
2654.00
2294.20
1704.80
Average total liabilities
9169.30
8995.10
7931.85
Cash flow from operations to
total liabilities ratio
28.94%
25.50%
21.49%
The results show that Woolworths had sufficient cash flow in 2008 to pay 28,94% of its total debts referred into the balance sheet. Stickney argues that a firm is considered healthy if it has an average of 20% or more regarding this ratio (Stickney et al., 2007, p.270). Based on this, Woolworths could be compared to an organisation in which the long-term liquidity-risk is low.
The interest coverage ratio corresponds to the annual earnings before interest and income tax (EBIT) divided by the interest expense (Tracy, 2009, p.131). Basically, it is used in order to assess the ability of a firm to pay interest on outstanding debt.
Woolworths
2008
2007
2006
Profit before interest and income taxes
2528.80
2111.30
1722.20
Interest expense
191.30
233.60
249.70
Interest coverage ratio
13.22
9.04
6.90
Although there is no standard rule for this ratio (Tracy, 2009, p.131), analysts argue that an interest coverage ratio below 3.0 is risky (Stickney et al., 2007, p.271). Based on this, Woolworths can be considered as a non-risky company regarding this ratio.
Liquidity and solvency, which one is more important?
These ratios must be analysed differently from one industry to another. Since supermarkets such as Woolworths or Wesfarmers have low receivables, low cash and medium inventories, they are more likely to operate on 'tight liquidity ratios' (Boscia, 2009). Tracy argues that maintaining solvency is crucial for every business (Tracy, 2009, p.129). This is particularly true in the case of Woolworths in which the solvency ratios are sensitively more optimistic compared to the liquidity ones. Moreover, solvency deals with the long term strategy of the company whereas liquidity considers the short term. In this context, it can be argued that solvency is more important since it deals with the long term survival of the organisation.
