Week 3

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Chapter 6

Liquidity of Short-Term Assets; Related Debt-Paying Ability

Current assets (1) are in the form of cash, (2) will be realized in cash, or (3) conserve the use of cash

Within the operating cycle of a business or one year, whichever is longer

Typical examples

Cash, marketable securities, receivables, inventories, and prepayments

Current Assets

The time period between the acquisition of goods and the final cash realization from sales

Operating Cycle

Purchase inventory

Cash sale to customer

Purchase material

Produce finished product

Sell to customer on credit

Collect amount due from customer

Retail and Wholesale

Manufacturing

Unrestricted

Available for deposit or to pay creditors

Reported as current asset

Restricted

Maybe reported as current but must disclose restrictions

Eliminate cash and related current liability when measuring short-term debt-paying ability

Current Assets: Cash

Compensating balance

A portion of loan proceeds required to remain on deposit in the bank

Increases effective interest rate

Against short-term borrowings

Separately stated in the current asset section or notes

Against long-term borrowings

Separately stated as noncurrent assets under either investments or other assets

Current Assets: Cash—Continued

The cash account on the balance sheet is usually entitled

Cash

Cash and equivalents, or

Cash and certificates of deposit

Analysis issues

Determining a fair valuation for the asset

Determining the liquidity of the asset

Current Assets: Cash—Continued

To qualify as a marketable security

The investment must be readily marketable

Intention to convert it to cash within the year or the operating cycle, whichever is longer

Examples

Treasury bills, short-term notes of corporations, government bonds, corporate bonds, preferred stock, and common stock

Debt and equity securities are carried at fair value

Current Assets: Marketable Securities

Claims to future cash inflows

Accounts receivables

Notes receivables

Arise from sales to customers

Trade receivables

Valuation problems

The entity incurs costs for the use of the funds, until receivables are collected

Collection might not be made

Current Assets: Receivables

Valuation of receivables

Waiting period is ignored

Assume stipulated rate of interest is fair

Notes that are noninterest-bearing, or carry an unreasonable rate, or are for an amount different from value of transaction are recorded at present value

Causes of impairment

Uncollectibility

Discounts allowed

Allowances given

Sales returns

Current Assets: Receivables—Continued

Impairment—Accrue (allowance method)

Based on estimate of receivables’ realizable value

Set up allowance

Expense recognized on income statement

Asset reduced by “Allowance for Doubtful Debts” account

Charge-off of a specific receivable

Reduces accounts receivable and allowance for doubtful accounts

No impact on income statement or net assets

Current Assets: Receivables—Continued

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

Current Assets: Receivables—Continued

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

Current Assets: Receivables—Continued

Customer concentration

May impair the quality of receivables if a large portion of receivables is from a few customers

Liquidity measures

Number of days’ sales in receivables

Accounts receivable turnover

Current Assets: Receivables—Continued

Should mirror the company’s credit terms

Indicates the length of time that the receivables have been outstanding

Use of the natural business year (lower sales at year-end) can understate result

Compare

Firm’s data for several years

Other firms in the industry and industry averages

Days’ Sales in Receivables

Causes for overstatement

Sales volume expands materially late in the year

Uncollectibles should have been written off

A company seasonally dates invoices

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

A company has a factoring arrangement in which a material amount of the receivables is sold

Days’ Sales in Receivables—Continued

Indicates the liquidity of receivables

Determining average gross receivables

End of year and beginning of year base points for average mask seasonal fluctuations

For internal analysis, use monthly or weekly amounts

For external analysis, use quarterly data

Accounts Receivable Turnover

Similar to days’ sales in receivables except average gross receivables are used

Should reflect firm’s credit and collection policies

Accounts Receivable Turnover in Days

Held for sale in the ordinary course of business

Used in the production of goods

Trading concern

Single (merchandise) inventory account

Manufacturing concern

Three distinct inventory accounts

Raw materials inventory

Work-in-process inventory

Finished goods inventory

Current Assets: Inventories

Perpetual

A continuous record of physical quantities is maintained

Inventory and cost of goods sold are updated as sales and purchases take place

Records are verified through physical inventory

Periodic

Periodic physical counts to determine quantity

Attach costs to ending inventory based on selected cost flow assumption(s)

Current Assets: Inventories—Continued

Specific identification

Tracking of specific cost normally impractical

Exceptions to this are large and/or expensive items

If specific costs are used, it is referred to as the specific identification method

Cost flow assumptions

FIFO (first-in, first-out)

LIFO (last-in, first-out)

Averaging

Inventory Cost

First inventory acquired is the first sold

Cost of goods sold includes oldest costs

Current costs are not matched against current revenue

Inflates profits during a time of inflation

Ending inventory reflects latest costs

Approximates replacement cost

Low turnover can distort the approximation of replacement cost

FIFO Cost Flow Assumption

Cost of latest acquired goods are matched against sales revenue

Improves the matching of current costs against current 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

LIFO Cost Flow Assumption

Determines a midpoint to calculate cost

Results in an inventory amount and a cost of goods sold amount somewhere between FIFO and LIFO

During times of inflation

Inventory is more than LIFO and less than FIFO

Cost of goods sold is less than LIFO and more than FIFO

Average Cost

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

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

If LIFO method is being used, short-term debt-paying ability is understated

Understatement is reduced by reported operating expenses that reduce gross profit to net income

Replacement cost of the inventory usually exceeds the reported inventory cost, even if FIFO is used

Analysis Problems and Inventory

Cash flow is higher when LIFO is used for tax reporting

LIFO generally results in a lower profit LIFO profit reflects current costs of sales

FIFO inventory is closer to replacement value of the asset

LIFO reserve

Measures the spread between LIFO and FIFO inventory value

Discloses the approximate FIFO inventory value

Impact on Financial Statements

Cost flow assumptions use historical data

If “utility” (market) is below cost, inventory must be written down to reflect the diminished value

Market is defined in terms of

Replacement cost

Net realizable value

Inventory: Lower-of-Cost-or-Market

Days’ sales in inventory

Inventory turnover in times per year

Inventory turnover in days

Liquidity of 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

Days’ Sales in Inventory

Implications of extremes

A high inventory would result in the number of days’ sales in inventory to be overstated and the liquidity to be understated

A low inventory would result in an unrealistic days’ sales in inventory; lost sales

Days’ Sales in Inventory—Continued

Indicates the liquidity of inventory

Determining average inventory

End of year and beginning of year base points for average mask seasonal fluctuations

For internal analysis use monthly or weekly amounts

For external analysis use quarterly data

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

Inventory Turnover—Continued Comparison Issues

Inventory Turnover in Days

The period between acquisition of goods and the final cash realization from sales

Current Assets: Operating Cycle

Subject to potential understatement from understatement of turnover measures

Use of LIFO inventory

Use of a natural business year

Averages are computed based on beginning-of-year and end-of-year data

Prepayments

Unexpired costs for which payment has been made

Consumed within an operating cycle or a year, whichever is longer

Have minor influence on short-term debt-paying ability

Valuation is taken as the cost that has been paid

No liquidity computation is needed as prepayment will not result in a receipt of cash

Current Assets: Prepayments

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

Current Assets: Other

Obligations whose liquidation is reasonably expected to require

The use of existing resources properly classifiable as current asset

The creation of other current liabilities

Typical Examples

Accounts payable, notes payable, accrued wages, accrued taxes, collections received in advance, and current portions of long-term liabilities

Carried at its face value

Current Liabilities

Liquidity Ratios

Indicates short-run solvency of a business

Subject to understatement if certain assets are understated (i.e., LIFO inventory)

Longitudinal comparison appropriate

Inter-firm comparison is of no value because of their size differences

Working Capital

Determines short-term debt-paying ability

Focus is on the relationship between current assets and current liabilities

Inter-firm comparison is possible and meaningful

Minimum current ratio is 2.00

Decreased current ratio indicates lower liquidity

Industry averages provide contextual benchmarks

Considerations

Quality of inventory and receivables

Inventory cost flow assumptions

Current Ratio

Measures the immediate liquidity of the firm

Relates the most liquid assets to current liabilities

Excludes inventory

A more conservative computation excludes other current assets that do not represent current cash flow

Minimum acid-test ratio is 1.00

Industry averages provide contextual benchmarks

Consideration

Quality of receivables

Acid-Test (Quick) 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 inventories and receivables

Firms that are highly speculative

Cash Ratio

Measures the turnover of working capital per year

Analyst compare this data with historical data, competitors, and industry averages to determine the adequacy of working capital

Assessment

Low ratio indicates unprofitable use of working capital

High ratio indicates that the firm is undercapitalized

Sales to Working Capital

Liquidity is better than indicated by financial statements

Unused bank credit lines

Long-term assets can be converted to cash quickly

A firm may be in a very good long-term debt position

Liquidity is weaker than indicated by financial statements

Co-signer on debt of another entity

Subject to recourse obligation

Significant contingent (unaccrued) liabilities

Other Liquidity Considerations

Gross Receivables

Days' Sales in Receivables =

Net Sales365

Net Sales

Accounts Receivable Turnover =

Average Gross Receivables

Average Receivable Turnover in Days =

Net Sales365

DateDescription

Number

of Units

Cost per

Unit

Total

Cost

Cost of

Goods Sold

01-JanBeginning inventory200 6.00$ 1,200$

01-MarPurchase1,200 7.00 8,400

01-JulPurchase300 9.00 2,700

01-OctPurchase400 11.00 4,400

2,100 16,700$

FIFO

01-OctPurchase400 11.00$ 4,400$

01-JulPurchase300 9.00 2,700

01-MarPurchase100 7.00 700

Ending inventory800 7,800$

Cost of Goods Sold8,900$

LIFO

01-JanBeginning inventory200 6.00$ 1,200$

01-MarPurchase600 7.00 4,200

Ending inventory800 5,400$

Cost of goods sold11,300$

Sheet1

Date	Description	Number of Units	Cost per Unit	Total Cost	Cost of Goods Sold
1-Jan	Beginning inventory	200	$ 6.00	$ 1,200
1-Mar	Purchase	1,200	7.00	8,400
1-Jul	Purchase	300	9.00	2,700
1-Oct	Purchase	400	11.00	4,400
		2,100		$ 16,700
FIFO
1-Oct	Purchase	400	$ 11.00	$ 4,400
1-Jul	Purchase	300	9.00	2,700
1-Mar	Purchase	100	7.00	700
	Ending inventory	800		$ 7,800
	Cost of Goods Sold				$ 8,900
LIFO
1-Jan	Beginning inventory	200	$ 6.00	$ 1,200
1-Mar	Purchase	600	7.00	4,200
	Ending inventory	800		$ 5,400
	Cost of goods sold				$ 11,300

Sheet2

Sheet3

AVERAGE COST

DateDescription

Number of

Units

Cost per

UnitTotal Cost

01-JanBeginning inventory200 6.00$ 1,200$

01-MarPurchase1,200 7.00 8,400

01-JulPurchase300 9.00 2,700

01-OctPurchase400 11.00 4,400

2,100 16,700$

Total Cost$16,700

Average unit cost = $7.95

Total Units2,100

Sheet1

AVERAGE COST
Date	Description	Number of Units	Cost per Unit	Total Cost
1-Jan	Beginning inventory	200	$ 6.00	$ 1,200
1-Mar	Purchase	1,200	7.00	8,400
1-Jul	Purchase	300	9.00	2,700
1-Oct	Purchase	400	11.00	4,400
		2,100		$ 16,700
1-Oct	Purchase	400	11.00	4,400
1-Jul	Purchase	300	9.00	2,700
1-Mar	Purchase	100	7.00	700
	Ending inventory	800		7,800
	Cost of Goods Sold			8,900
LIFO
1-Jan	Beginning Inventory	200	$ 6.00	$ 1,200
1-Mar	Purchase	600	7.00	4,200
	Ending inventory	800		$ 5,400
	Cost of Goods Sold			$ 11,300

Sheet2

Sheet3

Ending Inventory

Days’ Sales in Inventory

Cost of Goods Sold365

Cost of Goods Sold

Inventory Turnover =

Average Inventory

Inventory Turnover in Days =

Cost of Goods Sold365

365

Inventory Turnover per Year =

Inventory Turnover in Days

Operating Cycle = Accounts Receivable Tu

rnover in Days + Inventory Turnover in D

ays

Current Assets Inventory

Acid-Test (Quick) Ratio =

Current Liabilities

Current Assets

Current Ratio =

Current Liabilities

Cash Equivalents

+ Marketable Securities

+ Net Receivables

Acid-Test (Quick) Ratio =

Current Liabilities

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Working Capital = Current Assets Curren

t Liabilities

Cash Equivalents + Marketable Securities

Cash Ratio =

Current Liabilities

Sales

Sales to Working Capital =

Average Working Capital