The Finance Gem 💎 Week #65: Liquidity vs Solvency vs Cash Flow and Finance Confusions

THIS WEEK’S ISSUE AT A GLANCE

1. This week’s finance Gems 💎 vote your favorite in the poll section

   • 20 Confusing Finance Topics to Know.

   • Liquidity and Solvency are not the same.

   • Is Your Cash Flow Statement Direct or Indirect?

2. The Cash Flow vs EBITDA Poll Closed: see the results below and let me know what you think.

3. Click the image to vote in another Live Linkedin Poll:

   

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THIS WEEK’S FINANCE GEMS

1. 20 Confusing Finance Topics to Know.

Even the most seasoned finance professionals can get some of these wrong.

Because nobody lives through every learning experience.

And Finance is Confusing!

Here’s a list of 20 Confusing Finance Topics, what they mean and how to improve.

1. Gross Margin vs. Net Margin

2. Cash Flow vs. Profit

3. EPS Growth vs. Revenue Growth

4. Debt-to-Equity vs. Interest Coverage

5. ROI vs. IRR

6. Book Value vs. Market Value

7. Operating Expenses vs. Capital Expenditures

8. Fixed Costs vs. Variable Costs

9. Current Ratio vs. Quick Ratio

10. P/E Ratio vs. P/B Ratio

11. Accrual Accounting vs. Cash Accounting

12. Economic Profit vs. Accounting Profit

13. Operating Leverage vs. Financial Leverage

14. Amortization vs. Depreciation

15. Marginal Cost vs. Average Cost

16. Liquidity vs. Solvency

17. Cash Conversion Cycle vs. Operating Cycle

18. Forward P/E vs. Trailing P/E

19. Contribution Margin vs. Operating Margin

20. Market Capitalization vs. Enterprise Value

Download a copy of the carousel here.

My EBITDA Poll closed this week on Linkedin with 3.524 votes casted, 82% in favor of Cash Flow.

2. Liquidity and Solvency are not the same.

Liquidity and Solvency are not the same.

Just don’t get them confused.

Here’s how they’re different

And why you should care.

▶️ Liquidity impacts your today

▶️ Solvency impacts your tomorrow.

They serve different functions and have different implications.

Understanding how they are different can save your company

From a liquidity crunch, from insolvency, or even from bankruptcy.

Here are 4 critical differences you need to know:

🎯 They have different time horizons:

➡️ Liquidity: Short-term; usually focused on a 12-month period, ensuring you can meet immediate financial obligations.

➡️ Solvency: Long-term; spans years, ensuring your company has the required runway ahead to remain a viable business.

🎯 They use different financial KPIs:

➡️ Liquidity uses balance-sheet-centric, emphasizing short-term health.

Examples: Current Ratio, Quick Ratio, and Cash Ratio.

➡️ Solvency uses metrics that cross the income statement and balance sheet, examining long-term viability.

Examples: Debt-to-Equity Ratio, Interest Coverage Ratio, Funded Debt to EBIT, Fixed Charge Coverage Ratio

🎯 They monitor different underlying business concerns:

➡️ Liquidity is a timing issue testing for enough cash or easily convertible assets to cover immediate liabilities

➡️ Solvency is a mix of profitability and cash flow measuring if your business model is sustainable in the long run

🎯 They come with different consequences when ignored

➡️ Liquidity: Expect a cash crunch, operational setbacks, and tarnished creditworthiness.

If it continues beyond the current operating cycle and requires debt working capital financing, it may convert into a solvency problem, where not enough assets will be available to fund future payment obligations

➡️ Solvency: Expect risk of bankruptcy, investor mistrust, and long-term failure.

3. Is Your Cash Flow Statement Direct or Indirect?

Cash flow statements have 3 main sections:

➡️ Operating cash flows / Cash flow from operations

➡️ Investing cash flows / Cash flows from investing

➡️ Financing cash flows / Cash flows from financing

⚫ The only difference between the direct and indirect cash flow statements is how you calculate 𝐨𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰𝐬.

1️⃣ 𝐇𝐞𝐫𝐞'𝐬 𝐡𝐨𝐰 𝐭𝐨 𝐜𝐚𝐥𝐜𝐮𝐥𝐚𝐭𝐞 𝐨𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰𝐬 𝐢𝐧 𝐭𝐡𝐞 𝐢𝐧𝐝𝐢𝐫𝐞𝐜𝐭 𝐦𝐞𝐭𝐡𝐨𝐝:

✔️ start with net income from the Income Statement, which has been reported using accrual accounting

✔️ because your accrual income statement recognized revenues and expenses when they were incurred not when they were settled, it needs to be de-accrued to convert it into cash

✔️make adjustments for non-cash transactions such as depreciation and amortization, share based compensation, gains or losses from the sale of fixed assets or investments

✔️ make adjustments for non-operating items considered in the other two sections of the cash flow statement (e.g. dividend payments received potentially included in investing cash flows,)

✔️ make adjustments for changes in current assets and current liabilities (receivables, payables, inventories, prepaids, accruals)

2️⃣ 𝐇𝐞𝐫𝐞'𝐬 𝐡𝐨𝐰 𝐭𝐨 𝐜𝐚𝐥𝐜𝐮𝐥𝐚𝐭𝐞 𝐨𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰𝐬 𝐢𝐧 𝐭𝐡𝐞 𝐝𝐢𝐫𝐞𝐜𝐭 𝐦𝐞𝐭𝐡𝐨𝐝:

✔️ directly net the cash collections and disbursements during the period

✔️ instead of reconciling the accrual income statement, directly consider cash based inflows and outflows from operations

✔️ add:

▪️net cash from customers

▪️cash paid to employees

▪️cash paid to suppliers

▪️cash paid for interest

▪️cash paid for taxes

🎯 Remember:

⚫ Accounting frameworks offer you a choice between the indirect and the direct method.

⚫ Investors and analysts frequently prefer the direct method because it provides more transparency into your company's cash flows and shows the actual cash you received and paid out during the period.

⚫ Most companies however choose the indirect method, because it’s faster to get access to the required information, and thus easier to put together.

🎯 This is an excerpt from my 5⭐ rated Cash Flow Masterclass. Learn direct vs. indirect cash flow like nowhere else! Tell the cash flow story, drive strategy and start compounding your impact and influence in less than 2 hours, bite-size lessons, and lifetime access.

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POLL TIME

As always, if you have specific suggestions or feedback, or topic suggestions, simply reply to this email.

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