liquidity of short-term assets; related debt-paying ability copyright ©2007 thomson south-western,...

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 Wholesale Manufacturing


Receivables Issues

• Typically collected in 30 days• Valuation

– Impairments• Uncollectibility• Allowed discounts• Allowances given• Returns


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



• 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



• 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


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

Gross ReceivablesNet Sales

365


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


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

Net Sales

Average Gross Receivables


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

Average Gross ReceivablesNet Sales

365


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


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)


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


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


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


Cost Flow Assumption Example

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$

FIFO1-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

LIFO1-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$

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

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$

800 units of ending inventory are valued at average unit cost.

Total Cost $16,700 = $7.95

Total Units 2,100

Ending inventory (800 × $7.95) = $6,360Cost of goods sold ($16,700 – $6,360) = $10,340

2,100 units available for sale.

Average Cost


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


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


Liquidity of Inventory

• Number of days’ sales in inventory• Inventory turnover in times per year• Inventory turnover in days


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

Ending InventoryCost of Goods Sold

365


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

Cost of Goods Sold

Average Inventory


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 in Days

Average InventoryCost of Goods Sold

365

Inventory Turnover per Year

365

Inventory Turnoverin Days


Current Assets: Operating Cycle

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

Accounts Reciveable InventoryOperating Cycle = Turnover + Turnover

in Days in Days

• 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


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


Current Ratio

Current Assets

Current Liabilities

Acid-Test (Quick) Ratios

Current Assets - Inventory

Current Liabilities

Cash Equivalents+ Marketable Securities+ Net Receivables

Current Liabilities


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


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


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

Cash Equivalents + Marketable Securities

Current Liabilities


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

Sales

Average Working Capital


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

liquidity of short-term assets; related debt-paying ability copyright ©2007 thomson south-western,...

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