Chapter 6 Liquidity of Short-Term Assets; Related Debt-Paying Ability

Chapter 6, Slide #1

Current Assets
Current assets
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 Receivables Prepayments Marketable securities Inventories

Chapter 6, Slide #2

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

Collect amount due from customer

Chapter 6, Slide #3

Current Assets: Cash

Unrestricted
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

Chapter 6, Slide #4

Current Assets: Marketable Securities

Debt (bond/loan)and equity (stocks) securities
Treasury bills, short-term notes of corporations, government bonds, corporate bonds, preferred stock, and common stock.

Readily marketable
Managerial intent to convert to cash within the year or the operating cycle, whichever is longer

Chapter 6, Slide #5

Current Assets: Receivables

Claims to future cash inflows Arise from sales to customers
Trade (account) receivables Notes receivable

Chapter 6, Slide #6

Current Assets: Receivables (contd)

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

Chapter 6, Slide #7

Current Assets: Receivables (contd)

Two ways of reporting losses from credit sales (account receivable)
1. Direct write-off method 2. Allowance method (Allowance for Doubtful Accounts)

Chapter 6, Slide #8

Current Assets: Receivables (contd)

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

Liquidity of the trade receivables, there are two computations:

Number of days sales in receivables Accounts receivable turnover

Chapter 6, Slide #9

Days Sales in Receivables

Gross Receivables Net Sales 365
Should mirror the companys 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

Chapter 6, Slide #10

Days Sales in Receivables (contd)

Causes for understatement Sales volume decreases materially late in the year The company has a factoring arrangement in which a material amount of the receivables is sold to an outside party 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
Chapter 6, Slide #11

Example
Average Sales per day for the entire year $2,000 Sales per day at the end of the natural business year =$1,000 Gross receivables at the end of the year $100,000 Days sales in receivables: 100,000/2,000 = 50 days Days sales in receivables: 100,000/1,000 = 100 days = (understated, liquidity be overstated)
Chapter 6, Slide #12

Accounts Receivable Turnover (time)

Net Sales Average Gross Receivables

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
Chapter 6, Slide #13

Accounts Receivable Turnover in Days

Average Gross Receivables Net Sales 365

Similar to Number of Days Sales in Receivables except average receivables are used Should reflect firms credit and collection policies
Chapter 6, Slide #14

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

Chapter 6, Slide #15

Inventory
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)
Chapter 6, Slide #16

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

Chapter 6, Slide #17

FIFO Cost Flow Assumption

First inventory acquired is the first sold Cost of goods sold is oldest costs
Costs are low in relation to current costs Current costs are not matched against revenue Inflationresulting profit is overstated

Ending inventory reflects latest costs

Approximates replacement cost Slow turnover can distort the approximation of replacement cost by ending inventory value

Chapter 6, Slide #18

LIFO Cost Flow Assumption

Cost of most recently-acquired goods are matched against sales revenue
Inflationresulting profit value is fairly realistic

Ending inventory contains oldest costs

Inventory valuation can be based on costs that are years or decades old, some inventory values will not reflect current replacement costs

Chapter 6, Slide #19

Cost Flow Assumption Example

Cost Number Date 1-Jan 1-Mar 1-Jul 1-Oct Description Beginning inventory Purchase Purchase Purchase of Units 200 1,200 300 400 2,100 400 300 100 800 per Unit $ 6.00 7.00 9.00 11.00 Total Cost $ 1,200 8,400 2,700 4,400 $16,700 $ 4,400 2,700 700 $ 7,800

2,100 units available for sale.

FIFO 1-Oct Purchase 1-Jul Purchase 1-Mar Purchase Ending inventory Cost of Goods Sold LIFO 1-Jan Beginning inventory 1-Mar Purchase Ending inventory Cost of goods sold

$11.00 9.00 7.00

800 units of ending inventory are valued at the most recent 8,900 costs.

200 600 800

$ 6.00 7.00

$ 1,200 4,200 $ 5,400

800 units of ending inventory are valued at the $11,300 oldest costs.
Chapter 6, Slide #20

Cost Flow Assumption Example

Cost

Average Cost
Date 1-Jan 1-Mar 1-Jul 1-Oct Description Beginning inventory Purchase Purchase Purchase

Number of Units

per Unit Total Cost

200 $ 6.00 $ 1,200 1,200 7.00 8,400 300 9.00 2,700 400 11.00 4,400 2,100 $ 16,700

2,100 units available for sale.

Total Cost $16,700 = $7.95 Total Units 2,100

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

$6,360 $10,340

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

Specific Identification
Ending inventory (800x$7.00) = Cost of Goods Sold ($16,700 5,600)

Inventory cost
$5,600

COGS
$11,100

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

Chapter 6, Slide #22

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

Chapter 6, Slide #23

Days Sales in Inventory

Ending Inventory Cost of Goods Sold 365

Indicates the length of time needed to sell all inventory on hand Use of a natural business year
Understates number of days sale in inventory Overstates liquidity of inventory

Chapter 6, Slide #24

Inventory Turnover(time)
Cost of Goods Sold Average Inventory

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
Chapter 6, Slide #25

Inventory Turnover in Days

Average Inventory Cost of Goods Sold 365

Inventory Turnover per Year

365 Inventory Turnover in Days

Chapter 6, Slide #26

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 Typical items: carried at face value
accounts payable, notes payable, accrued wages, accrued taxes, collections received in advance, and current portions of long- term liabilities. Chapter 6, Slide #27

Current Assets Comparing with Current Liabilities

1. 2. 3. 4. Working capital Current ratio Acid- test ratio Cash ratio

Chapter 6, Slide #28

Working Capital
Working Capital = Current Assets Current Liabilities

Subject to understatement if certain assets are understated (i.e., LIFO inventory) Longitudinal comparison appropriate Inter-firm comparison is of no value
Chapter 6, Slide #29

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
Chapter 6, Slide #30

Current Ratio
Current Assets Current Liabilities

Acid-Test (Quick) Ratios

Current Assets - Inventory Current Liabilities

Chapter 6, Slide #31

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
Chapter 6, Slide #32

Cash Ratio
Cash Equivalents + Marketable Securities Current Liabilities

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

Chapter 6, Slide #33

Reference
Gibson, C.H. (2009). Financial Reporting & Analysis: Using Financial Accounting Information. 11th ed. Norwalk, Connecticut: South-Western Cengage Learning.