King

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
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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
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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
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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.

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Dos and Don’ts Do
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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 assume that all financial statements truly reflect a company’s financial position. Measuring and reporting permit considerable discretion and the opportunity to influence results.

Don’t
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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.
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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 An example from our Balance sheet: 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 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. 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 An example from our Balance sheet: 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:
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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. 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 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 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

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 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% 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 An example from our Balance sheet and Income Statement: 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 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 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 An example from our Balance sheet and Income Statement: Total Net Profit after Interest and Taxes (from Income Statement) = $5,142 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. 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. 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 An example from our Balance sheet and Income Statement: Total Net Profit after Interest and Taxes (from Income Statement) = $5,142 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. 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. 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 An example from our Balance sheet and Income Statement: 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 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 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 An example from our Balance sheet and Income Statement: Total Net Profit after Interest and Taxes (from Income Statement) = $5,142 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. 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. 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 An example from our Balance sheet and Income Statement: Total Net Profit after Interest and Taxes (from Income Statement) = $5,142 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:

For Better Hotels in 2005 this is:

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

For Better Hotels in 2004 this is:

For Better Hotels in 2005 this is:

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 nonprofitable 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 BSE: 500325 LSE: RIGD Conglomerate 1966 As Reliance Commercial Corporation Dhirubhai Ambani Mumbai, Maharashtra, India Worldwide Mukesh Ambani (Chairman & MD) Petroleum Natural gas

Type Industry Founded Founder(s) Headquarters Area served Key people Products

Petrochemicals Retail stores Polymers Polyesters Chemicals Textile Telecommunications Revenue Operating income Net income Total assets Total equity Employees 203,740.00 crore (US$44.21 billion) (2010) 28,680.00 crore (US$6.22 billion) (2010) 15,818.00 crore (US$3.43 billion) (2010) 245,706 crore (US$53.32 billion) (2009) 146,328 crore (US$31.75 billion) (2009) 24,679 (2009) Reliance Petroleum Reliance Life Sciences Reliance Industrial Infrastructure Limited Reliance Institute of Life Sciences Reliance Logistics Reliance Clinical Research Services Reliance Solar Relicord Infotel Broadband RIL.com

Subsidiaries

Website

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
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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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
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International Refiner of the Year in 2005 at the 23rd Annual Hart's World Refining and Fuels Conference .

Awards for managers
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• • • •

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 Dr. Dharam Vir Kapur 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 Dr. Dharam Vir Kapur 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 Dr. Dharam Vir Kapur 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