Liquidity of Short-Term Assets; Related Debt-Paying Ability COPYRIGHT ©2007 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 6

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #2 Operating Cycle The time period between the acquisition of goods and the final cash realization from sales Purchase inventory Cash sale to customer Purchase material Produce finished product Sell to customer on credit Collect amount due from customer Retail and WholesaleManufacturing

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #3 Receivables Issues Typically collected in 30 days Valuation –Impairments Uncollectibility Allowed discounts Allowances given Returns

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #4 Receivables Issues (cont’d) Impairment: Accrue (allowance method) –Based on estimate of receivables’ realizable value –Set up allowance Expense recognized on income statement Asset reduced by contra account “Allowance for Doubtful Accounts” or “Uncollectible Accounts” –Charge-off of a specific receivable Reduces accounts receivable and allowance for doubtful accounts No impact on financial income or net assets Deductible event for income taxes

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #5 Receivables Issues (cont’d) Impairment: Direct write-off –Alternative to accrual method when Receivables are not material or Amount for accrual cannot be reasonably estimated –Charge-off of a specific receivable Recognize expense Reduce asset –Bad debt expense likely to be recognized in a year subsequent to the sale Does not match expense with revenue

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #6 Receivables Issues (cont’d) Customer concentration –May impair the quality of receivables if a large portion of receivables is from a few customers Liquidity Ratios –Number of days’ sales in receivables –Accounts receivable turnover

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #7 Days’ Sales in Receivables Should mirror the company’s credit terms Reading reflects end-of-year status of receivables –Use of the natural business year (lower sales at year-end) can understate result Compare –Firm data for several years –Other industry firms and industry averages

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #8 Days’ Sales in Receivables (cont’d) Causes for overstatement –Sales volume expands materially late in the year –Receivables are uncollectible and should have been written off –The company seasonally dates invoices –A large portion of receivables are on the installment basis Causes for understatement –Sales volume decreases materially late in the year –A material amount of sales are on a cash basis –The company has a factoring arrangement in which a material amount of the receivables is sold to an outside party

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #9 Accounts Receivable Turnover Indicates the liquidity of receivables Determining average gross receivables –End of year and beginning of year base points for average mask seasonal fluctuations –Internal analysis: use monthly or weekly amounts –External analysis: use quarterly data

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #10 Accounts Receivable Turnover in Days Similar to Number of Days’ Sales in Receivables except average receivables are used Should reflect firm’s credit and collection policies

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #11 Inventory Issues Held for sale in the normal course of business Used in the production of goods Trading business –Wholesale to retail –Retail to end consumer –Single inventory (merchandise) account Manufacturer has three distinct inventories –Raw materials inventory –Work in process inventory –Finished goods inventory

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #12 Inventory Records Perpetual –A continuous record of Physical quantities is maintained Inventory and cost of goods sold, updated as sales and purchases take place –Records are verified through physical inventory Periodic –Periodic physical inventories to determine quantity –Attach costs to ending inventory based on selected cost flow assumption(s)

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #13 Inventory Cost Specific identification –Tracking of specific cost normally impractical –Exceptions: large and/or expensive items Cost flow assumptions –FIFO (first-in, first-out) –LIFO (last-in, first-out) –Average

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #14 FIFO Cost Flow Assumption First inventory acquired is the first sold Cost of goods sold is oldest costs –Current costs are not matched against revenue –Inflates profit Ending inventory reflects latest costs –Approximates replacement cost –Slow turnover can distort the approximation of replacement cost by ending inventory value

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #15 LIFO Cost Flow Assumption Cost of most recently-acquired goods are matched against sales revenue –Profit is reflective of replacement cost Ending inventory contains oldest costs –Inventory valuation can be based on costs that are years or decades old

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #16 Cost Flow Assumption Example 800 units of ending inventory are valued at the most recent costs. 800 units of ending inventory are valued at the oldest costs. 2,100 units available for sale.

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #17 Cost Flow Assumption Example 800 units of ending inventory are valued at average unit cost. Ending inventory (800 × $7.95) =$6,360 Cost of goods sold ($16,700 – $6,360) =$10,340 2,100 units available for sale. Average Cost

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #18 Impact on Financial Statements Cash flow is higher when LIFO is used for tax reporting LIFO profit generally lower than FIFO profit LIFO profit reflects current costs of sales LIFO reserve –Measures the spread between LIFO and FIFO inventory value –Discloses the approximate FIFO inventory value FIFO inventory is closer to replacement value of the asset

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #19 Inventory: Lower-of-Cost-or-Market Cost flow assumptions use historical data If “utility” (market) is below cost, inventory must be written down to reflect the diminished value Definitions of market –Replacement cost –Net realizable value

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #20 Liquidity of Inventory Number of days’ sales in inventory Inventory turnover in times per year Inventory turnover in days

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #21 Days’ Sales in Inventory Indicates the length of time needed to sell all inventory on hand Use of a natural business year –Understates number of day’s sale in inventory –Overstates liquidity of inventory Implications of extremes –High: excessive inventory for sales activity –Low: inventory shortage and lost sales

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #22 Inventory Turnover Indicates the liquidity of inventory Determining average inventory –End of year and beginning of year base points for average mask seasonal fluctuations –Internal analysis: use monthly or weekly amounts –External analysis: use quarterly data

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #23 Inventory Turnover Comparison Issues Use caution when comparing a mix of natural and calendar year companies Cost flow assumption issues –LIFO yields lower inventory value and higher inventory turnover Inter-industry comparisons may not be reasonable

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #24 Inventory Turnover in Days Inventory Turnover per Year

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #25 Current Assets: Operating Cycle The time period between acquisition of goods and the final cash realization from sales Subject to potential understatement from understatement of turnover measures –Use of LIFO –Use of a natural business year –Averages are computed on beginning-of-year and end-of-year data

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #26 Working Capital Subject to understatement if certain assets are understated (i.e., LIFO inventory) Inter-firm comparison is of no value Current Assets –Current Liabilities =Working Capital

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #27 Current Ratio Acid-Test (Quick) Ratios

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #28 Current Ratio Determines short-term debt-paying ability Focus is on the relationship between current assets and current liabilities –Inter-firm comparison is possible and meaningful Traditional benchmark: 2.00 –Decreased current ratio indicates lower liquidity –Industry averages provide contextual benchmark Considerations –Quality of inventory and receivables –Inventory cost flow assumptions

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #29 Acid-Test (Quick) Ratio Measures the immediate liquidity of the firm Relates the most liquid assets to current liabilities –Exclude inventory –More conservative variation: Also exclude other current assets that do not represent current cash flow Traditional benchmark: 1.00 –Industry averages provide contextual benchmark Consideration –Quality of receivables

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #30 Cash Ratio Extremely conservative –Unrealistic for a firm to have sufficient cash and securities to cover all its current liabilities Appropriate context –Firms with naturally slow-moving inventory and receivables –Firms that are highly speculative

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #31 Sales to Working Capital Measures the turnover of working capital per year Compare with –Historical data –Industry competitors –Industry averages Assessment –Low: potentially unprofitable use of working capital –High: potential undercapitalization

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 6, Slide #32 Other Liquidity Considerations Liquidity is better than indicated by financial statements –Unused bank credit lines –Noncurrent assets that can be converted to cash quickly Liquidity is weaker than indicated by financial statements –Co-signer on debt of another entity –Subject to recourse obligation on discounted receivables –Significant contingent (unaccrued) liabilities