June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 12 of 92 2. WHAT IS CAPITAL ADEQUACY? Capital adequacy is a vital financial perspective of any company. Capital adequacy analyses are designed to assess a company’s short and long term outlook for financial health. While other financial metrics emphasize financial performance vis-à-vis return measures, capital adequacy emphasizes financial capability to withstand adverse events. Because capital is an important barometer of financial health, capital adequacy provides investors increased confidence that a company is viable even in the face of much uncertainty. A robust assessment studies capital adequacy from two measurement frameworks ― 1) economic value and 2) financial liquidity. Even under adverse conditions, a company that has an adequate capital level must simultaneously possess 1) the capacity to create economic value for shareholders and, 2) ready sources of financial liquidity to meet maturing obligations. Weakness in either measure may indicate vulnerability for the business as a going concern. For this white paper, economic value and financial liquidity have the following connotations: • Economic value relates to the ability of a company to execute its planned business activities while creating or enhancing shareholder value. There are many sources of uncertainty in a company’s future cash flows, thereby creating uncertainty in its valuation. Although the expected economic value may be favorable, the business must have capital to withstand potential unfavorable outcomes to remain a viable competitive entity. This capital to withstand these potential unfavorable outcomes is known as “economic capital” or “risk capital”. • Financial liquidity relates to a company’s firm access to cash when needed to meet all sorts of demands. These cash demands arise simultaneously from the company’s physical and financial operations and must be met to continue for the long term and create economic value. Figure 2.1 graphically illustrates this concept of balancing Economic Value and Financial Liquidity.