Corporate Finance, 4th Edition

Chapter 14Conclusion of financial analysis

As one journey ends, another probably starts

By the time you complete a financial analysis, you must be able to answer the two following questions that served as the starting point for your investigations:

• Will the company be solvent? That is, will it be able to repay any loans it raised?
• Will it generate a higher rate of return than that required by those that have provided it with funds? That is, will it be able to create value?

Value creation and solvency are obviously not without links. A firm that creates value will most often be solvent and a company will most likely be insolvent because it has not succeeded in creating value.

Section 14.1 Solvency

Here we return to the concept that we first introduced in Chapter 4.

A company is solvent when it is able to honour all its commitments by liquidating all of its assets, i.e. if it ceases its operations and puts all its assets up for sale.

Since, by definition, a company does not undertake to repay its shareholders, its equity represents a kind of life raft that will help keep it above water in the event of liquidation by absorbing any capital losses on assets and extraordinary losses.

Solvency thus depends on:

• the break-up value of a company's assets;
• the size of its debts.

Do assets have a value that is independent of a company's operations? The answer is probably “yes” for the showroom of a carmaker on 5th Avenue in New York and probably “no” as far as the tools and equipment ...