ERNST Growth/Liquidity Analysis Model Concept
ERNST Growth/Liquidity Analysis Model was developed by Harry Ernst from the North American consultant Compumetrics for a company that was having cash problems originated by an increase of orders. The responsible for the company were frustrated with the difficulty to manage growth and liquidity through conventional financial demonstrations and wanted a demonstration that offered clear information about liquidity. The model developed modifies the standard format of the balance, allowing a more clear vision of the tendencies in liquidity and also allowing a better cash-flow management in periods of fast growth and investment.
How to use the model:
The instructions to use the model are the following:
- Restructure balance to create a growth/liquidity balance. For that should be combined the existences with long term assets on the growth column. Following subtract this total of the shareholders equity (withheld profits + equity) as a way to express the deficit or surplus capacity to additionally invest in assets that generate growth.
- Subtract all the short and long term liabilities of the financial assets (such as availabilities and debts to receive); from there will result operational liquidity. Then, should be restructured the balance like presented below.
|Shareholders’ equity||Cash and debts to receive (financial assets)|
Land, buildings and equipment
Short term liabilities
Long term liabilities
Growth surplus or deficit
- Analyze tendencies on assets that generate growth and operational liquidity, searching for information about the company’s financial condition or to predict future behavior.
- Can be obtained additional information drawing an operational curb, which represents the relation between operational liquidity annual variations and assets annual variations that generate growth. For that, the growth/liquidity balance should be made for at least 5 years. Therefore are used assets subsequent totals that generate growth to calculate the annual percentage variation; alongside are also calculated annual percentage variations in operational liquidity. After is divided the percentage variation of each year either for the assets that generate growth, either for the liquidity by the sales values correspondent to the most recent year to convert them in sales.
- Draw a graphic with the investment capital values on the horizontal axis and the liquidity values on the vertical axis. On this graphic, trace a regression line of square minimums that follow the tendency of the represented points – this line’s inclination reflects the relation between the assets that generate growth and the liquidity of a certain company. For example, an inclination of -1 shows that liabilities grow faster than equity, not representing significant variations in financial assets.
- Find the point where the operational curb intersects a horizontal line that passes in the 0 point of the vertical axis. This point represents operational balance, this is, the maximum growth without external indebtedness. If the company is under this point on its operational curb, there is a space that needs to be filled with long term funding. If the company drops below its operational curb, should occur a debt increase and the investment in assets that generate growth should go down until the liquidity is restored.
- It’s also possible to use the graphic to identify the maximum growth rate viable with the external funding. For that should be calculated annual variations of withheld profits divided by sales. Following, draw the withheld profits annual value in relation to the annual variation in assets that generate growth and connect the points with a line. After draw a vertical line on the graphic where the distances from the zero growth horizontal line until the withheld profits curb and the operational curb are equal. This vertical line (which represents an upright strategic balance) intercepts the horizontal axis at the investment growth rate value that is consistent with the capacity of the company to generate sales and profits. If the company goes under the upright strategic balance probably will have to compensate with a change to another direction in the future.
- The graphic can also be used to analyze strategy, using it to perform comparisons with the competitors. Can be used to evaluate, for example, which companies that have been more aggressive regarding growth and which are more indebted or far from the strategic balance.