1. Liquidity of Short-Term Assets; Related Debt-Paying Ability
Chapter 6
Liquidity of Short-Term Assets; Related Debt-Paying Ability
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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
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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
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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
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5. Current Assets: Cash (cont’d)
Compensating balance
A portion of loan proceeds required to be retained on deposit
Increases effective interest rate
Against current liability
Part of current assets; disclosure
Against noncurrent liability
Reported as noncurrent asset
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6. 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
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7. Current Assets: Receivables
Claims to future cash inflows
Arise from sales to customers
Trade (account) receivables
Notes receivable
Other current receivables
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8. Current Assets: Receivables (cont’d)
Valuation
Ignore cost of fund use for delayed collection
Assume rate of interest is reasonable
Notes that are noninterest-bearing carry an unreasonable rate, or are for an amount different from value of transaction are recorded at present value
Impairment
Uncollectibility
Allowed discounts
Allowances given
Returns
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9. Current Assets: Receivables (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”
Expense on income statement before deducted on tax return
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
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10. Current Assets: Receivables (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
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11. 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
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12. Current Assets: Receivables (cont’d)
Customer concentration
May impair the quality of receivables if a large portion of receivables is from a few customers
Liquidity
Number of days’ sales in receivables
Accounts receivable turnover
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13. 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
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14. 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
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15. 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
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16. 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
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17. 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
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18. Inventory Perpetual Periodic 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)
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19. 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
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20. 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
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21. 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
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22. Cost Flow Assumption Example
2,100 units available for sale.
800 units of ending inventory are valued at the most recent costs.
800 units of ending inventory are valued at the oldest costs.
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23. Cost Flow Assumption Example
Average Cost
2,100 units available for sale.
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
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24. Analysis Problems and Inventory
Short-term debt-paying ability is understated
Understatement is reduced by reported operating expenses that reduce gross profit to net income
Replacement cost exceeds LIFO or FIFO cost of goods sold
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25. 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
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26. 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
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27. Liquidity of Inventory
Number of days’ sales in inventory
Inventory turnover in times per year
Inventory turnover in days
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28. 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
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29. 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
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30. 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
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31. Inventory Turnover in Days
Inventory Turnover per Year
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32. 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
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33. Current Assets: Prepayments
Unexpired costs for which payment has been made
Have minor influence on short-term debt-paying ability
Valuation: use carrying cost
Liquidity: not an issue since no cash is expected to be received
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34. Current Assets: Other
Will be realized in cash or conserve the use of cash within the operating cycle of the business or one year, whichever is longer
If material, and nonrecurring, may distort liquidity
Examples
Property held for sale
Advances or deposits
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35. 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
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36. 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
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37. Acid-Test (Quick) Ratios
Current Ratio
Acid-Test (Quick) Ratios
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38. 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
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39. 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
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40. 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
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41. 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
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42. 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
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