1. HUANGHUAI UNIVERSITY & BANGOR UNIVERSITY Chapter 6 Liquidity of Short-Term Assets; Related Debt-Paying Ability DR. AZIZ JAAFAR

2. Current Assets Current assets Typical examples
In the form of cash or will be realized in cash or conserve the use of cash within the operating cycle, or one year, whichever is longer
Typical examples
Cash – Marketable securities
Receivables – Inventories
Prepayments

3. Operating Cycle
The time period between the acquisition of goods and the final cash realization from sales
Retail and Wholesale
Manufacturing
Purchase inventory
Cash sale to customer
Purchase material
Produce finished product
Sell to customer on credit
Collect amount due from customer

4. Current Assets: Cash Unrestricted Restricted
Available to pay creditors
Report as current asset
Restricted
May report as current but disclose restrictions
Eliminate cash and related current liability when measuring short-term debt-paying ability

5. Current Assets: Marketable Securities
Debt and equity securities
Readily marketable
Managerial intent to convert to cash within the year or the operating cycle, whichever is longer
Carried at fair value
Analysis:
Reclassify continuing investments as noncurrent

6. Current Assets: Receivables
Claims to future cash inflows
Arise from sales to customers
Trade (account) receivables
Notes receivable
Other current receivables

7. Current Assets: Receivables (cont’d)
Trade receivables
Typically collected within 30 days
Installment receivables
May be carried as a current asset yet collection may be significantly longer than trade receivables
Usually considered to be lower quality than trade receivables

8. 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

9. 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

10. 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

11. Current Assets: Inventories
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

12. Inventory Cost Specific identification Cost flow assumptions
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

13. Liquidity of Inventory
Number of days’ sales in inventory
Inventory turnover in times per year
Inventory turnover in days

14. 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

15. 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

16. 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

17. 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

18. Current Liabilities
Obligations whose liquidation is reasonably expected to require the use of existing resources properly classifiable as current asset or the creation of other current liabilities
Liquidity: not applicable
Valuation: carried at face value
Difference between present value and face value is immaterial and disregarded

19. Working Capital Longitudinal comparison appropriate
Current Assets – Current Liabilities = Working Capital
Subject to understatement if certain assets are understated (i.e., LIFO inventory)
Longitudinal comparison appropriate
Inter-firm comparison is of no value

20. Acid-Test (Quick) Ratios
Current Ratio
Acid-Test (Quick) Ratios

21. 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

22. 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

23. Cash Ratio Extremely conservative Appropriate context
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

24. 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

25. 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