Emerging Practices for Capital Adequacy © Copyright 2003, CCRO. All rights reserved. 3 prevailing business and regulatory climate create 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. • Financial liquidity relates to a company’s ability to meet demands for cash as they become due. These cash demands arise simultaneously from the company’s physical business activities and from its financial operations and are required to manage the risks inherent in creating economic value. Figure 1: The Components of Capital Adequacy – Balanced Economic Value and Financial Liquidity 1.2 The Components of Capital Adequacy for Economic Value 1.2.1 Framework for Assessing Capital Adequacy for Economic Value The framework for assessing capital adequacy (or inadequacy) for economic value requires quantitative evaluations of three components: 1. Net assets 2. Debt and debt-like instruments 3. Economic capital. Capital adequacy for economic value equals net assets less debt less economic capital (Figure 2). Methodologies for determining net assets and debt are described in general terms, and some high- level issues concerning their valuation are identified. What Capital Adequacy Means • Capital adequacy refers to the overall assessment of a company’s financial health as a “going concern” • A robust assessment of capital adequacy requires balance between two financial perspectives on “adequacy”… Capital Adequacy for Continuing Financial Liquidity: Liquidity Adequacy Capital Adequacy for Continuing Economic Value: Economic Capital Adequacy