 Operating cycle is used for classification of fixed or current assets.

Current assets are those

which are expected to be sold within 1 year or operating cycle. Current assets include cash,
receivables, inventories, short term investments.

 Working capital is excess of current assets over current liabilities

 The concept of liquidity is important when analyzing the current assets. It gives flexibility as the
companies can take advantage in times of changing market conditions and they can react to
strategic actions by competitors.

 Analysts must consider the two conditions when they are analyzing cash and cash equivalents:
a) When cash and cash equivalents are invested in shares, they can pose a risk of reduction in
the liquidity as market value changes.
b) Companies could be required by the lenders to keep cash and cash equivalents at a specific
level as a compensating balance for the loans already taken.

 Receivables are the amounts owed by the company as a result of selling its goods or services.
 Companies report receivables at their net realizable value, i.e. total amount of receivables less
an allowance for bad debts. Management estimates the bad debts based on estimates based on
previous experience, economic conditions, industry trends.
 An analyst needs to consider the following points when analyzing receivables:
a) He must keep in mind the error of judgement and the management incentives to report
higher current assets.
b) In analyzing the receivables, the analyst must assess the collection risk by using tools such as
comparing competitors’ receivables as a percentage of sales, concentration of major portion
of receivables in few accounts.
c) The analysis of receivables must also account for the authenticity of receivables and
securitization of receivables.
 Prepaid expenses are the expenses paid in advance but services against them have not been
received.
Inventories
 Inventories are the goods which are held for sales during normal business operations.
 The methods used by the company to value inventories are critical in analysis. Commonly used
methods are FIFO and LIFO.
 In the periods of rising prices, the FIFO method reports a higher profits since the value of ending
inventory is large and hence reduces the COGS. The higher profits mean that the company has to
pay higher taxes which can pose significant liquidity problems for the company.
 In case of LIFO the company can go for greater tax savings due to lower profits and there is less
likelihood of inventor obsolescence.
 LIFO has another important implication. The value of inventory reported in the balance sheet
when carried at LIFO is understated when prices are rising. This also understates the company’s
ability to pay debts since the current ratio will be lower. To overcome this problem the analyst
can adjust LIFO statements to FIFO
 Inventory costing for manufacturing companies involves three components:
a) Raw material
b) Labor
c) Overheads
 The raw material and labor costs can be accurately determined. However, the overhead
allocation involves assumptions from the company since the allocation of overheads is based on
 cost drivers which is subject to management assumptions and decision. Therefore, the analyst
needs to be aware of that.
 Analysts need to be aware that inventories are reported at lower of cost or market value. If the
market value of inventory gets lower than the costs the reasons could be obsolescence, damage,
price changes. This decrease should be charged off in the income statement to reflect the loss.
 Analysts must also consider the impact of lower of cost or market value recognition principle.
When the prices in the economy are rising, this principle understates the values of inventory
irrespective of the method used for inventory valuation. It will also lead to a depressed current
ratio.
 Long term assets accounting involves three activities:
a) Capitalization means deferring the cost of the asset whose benefits are expected to extend
in the future periods.
b) Depreciation refers to periodic allocation of deferred cost as an expense in the income
statement.
c) Impairment refers to writing down the book value of long-term assets when its future cash
flows are not sufficient to cover the remaining cost reported on the balance sheet.