Financial Reports Analysis

Faculty of Commerce “English Section” – Level IV

- Course Code: ACC 401

Module Leader:
Dr. Mohamed Salem
Assistant Professor of Accounting
Suez University
Teaching Assistant:
MennatAllah Omar
 Class Policies

• Course Inquiries:
For any inquiries regarding lectures, tutorials, course materials
and appointments please do contact by official mail only:
muhammad.salem@com.suezuni.edu.eg

• Electronic Devices:
Laptops, tablets, or phones should only be used during class to
access the homework portal, review PowerPoint slides, or take
notes. Mobiles should be silenced before the class begin.
 Course Syllabus
Ø Chapter (1): Introduction to Financial Reporting.

Ø Chapter (2): Basics of Analysis.

Ø Chapter (3): Liquidity of Short-Term Assets; Related

Debt Paying Ability.

Ø Chapter (4): Long-Term Debt Paying Ability.

Ø Chapter (5): Profitability.

Ø Chapter (6): Expanded Analysis.

Ø Chapter (7): Special Industries: Bank Accounting.

 Recommended Textbook
Gibson, C. H., Financial Statement Analysis. 12th
Edition. Cengage Learning, Education, Inc.
 Chapter 3
Liquidity of Short-term
Assets and Related
Debt Paying Ability
 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
 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

 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
Activity Task
 Cost Flow Assumption Example

Number Cost per

Date Description of Units Unit Total Cost
2,100 units
01-Jan Beginning inventory 200 $ 6.00 $ 1,200
available for
01-Mar Purchase 1,200 7.00 8,400
01-Jul Purchase 300 9.00 2,700
sale and 800
01-Oct Purchase 400 11.00 4,400 units of
2,100 $ 16,700 ending
inventory
Required:
Compute both of cost of goods sold and ending inventory
balances using:
i. FIFO
ii. LIFO
iii. Weighted Average Cost
 Cost Flow Assumption Example
Cost
Number per Total
Date Description of Units Unit Cost
1-Jan Beginning inventory 200 $ 6.00 $ 1,200
1-Mar Purchase 1,200 7.00 8,400 2,100 units
1-Jul Purchase 300 9.00 2,700 available for
1-Oct Purchase 400 11.00 4,400 sale.
2,100 $16,700
FIFO
1-Oct Purchase 400 $11.00 $ 4,400 800 units of
1-Jul Purchase 300 9.00 2,700 ending inventory
1-Mar Purchase 100 7.00 700
are valued at the
Ending inventory 800 $ 7,800
most recent
Cost of Goods Sold 8,900 costs.
LIFO
1-Jan Beginning inventory 200 $ 6.00 $ 1,200 800 units of
1-Mar Purchase 600 7.00 4,200 ending inventory
Ending inventory 800 $ 5,400
are valued at the
Cost of goods sold $11,300 oldest costs.
 Cost Flow Assumption Example
Cost
Average Cost
Number per
Date Description of Units Unit Total Cost
1-Jan Beginning inventory 200 $ 6.00 $ 1,200
1-Mar Purchase 1,200 7.00 8,400 2,100 units
1-Jul Purchase 300 9.00 2,700 available for
1-Oct Purchase 400 11.00 4,400 sale.
2,100 $ 16,700

Total Cost $16,700

= = $7.95
Total Units 2,100
800 units of
Ending inventory (800 × $7.95) = $6,360 ending inventory
Cost of goods sold ($16,700 – $6,360) = $10,340 are valued at
average unit
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

• FIFO inventory is closer to replacement value of the asset

 Liquidity of Inventory

• Number of days’ sales in inventory

• Inventory turnover in times per year

• Inventory turnover in days

 Days’ Sales in Inventory
Ending Inventory
æ Cost of Goods Sold ö
ç ÷
è 365 ø

• Indicates the length of time needed to sell all

inventory on hand

• Implications of extremes
– High: excessive inventory for sales activity
– Low: inventory shortage and lost sales
 Inventory Turnover

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

– Internal analysis: use monthly or weekly amounts

– External analysis: use quarterly data

Inventory Turnover Comparison Issues

• Cost flow assumption issues

– LIFO yields lower inventory value and higher inventory
turnover

• Inter-industry comparisons may not be reasonable

Inventory Turnover Inventory Turnover
in Days per Year

Average Inventory 365

æ Cost of Goods Sold ö Inventory Turnover
ç ÷ in Days
è 365 ø
Activity Task
 Case
B-Tech Company has an ending inventory of $360,500
and a cost of goods sold for the year of $2,100,000. It has
used LIFO inventory for a number of years because of
persistent inflation.

Required:
i. Compute the days’ sales in inventory

ii. Is B-Tech Company’s days’ sales in inventory as computed

realistic in comparison with the actual days’ sales in
inventory?

iii. Would the days’ sales in inventory computed for B-Tech

Company be a helpful guide?
Solution
 Comment
b. No. Since B-tech Company uses LIFO inventory, the
ending inventory is computed using costs that are lower
than current costs due to the persistent inflation. The cost
of goods sold is representative of the approximate current
cost and, therefore, the average daily cost of goods sold is
representative of current cost. When the average daily
cost of goods sold is divided into the inventory, the result
is an unrealistically low number of days' sales in
inventory. Thus, the liquidity is overstated.
 Comment
c. The number of days' sales in inventory would be a
helpful guide when compared with prior periods. The
actual computed number of days' sales in inventory would
not be meaningful because of the LIFO inventory .
 Current Assets: Operating Cycle

• The time period between acquisition of goods and the final

cash realization from sales

Accounts Reciveable Inventory

Operating Cycle = Turnover + Turnover
in Days in Days
• Subject to potential understatement from understatement of
turnover measures
– Use of LIFO
– Averages are computed on beginning-of-year and end-of-
year data
 Current Assets: Prepayments

• 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
 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
 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
 Working Capital

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

 Acid-Test (Quick)
Current Ratio
Ratios
Current Assets Current Assets - Inventory
Current Liabilities Current Liabilities

æ Cash Equivalents ö
ç + Marketable Securities ÷
ç + Net Receivables ÷
è ø
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

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

 Sales to Working Capital
Sales
Average 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

Activity Task
Case

2019 2020 2021

2020 and 2021:

Solution
Solution
 Comment
• The short-term liquidity of the firm has improved
between 2020 and 2021. The working capital increased
by $60,000, while the current ratio increased from 1.33
to 1.47. The acid-test ratio increased from 0.67 to 0.74.
Using a rule of thumb of two for the current ratio and
one for the acid-test, this firm needs to improve its
current liquidity position.
 Comment
• The accounts receivable turnover stayed the same,
while the inventory turnover improved from 4.25 to
4.98. The days' sales in inventory improved from 85.88
to 73.29 days.

• Much of the improvement in the current position can be

attributed to the improved control of the inventory .
 Assignment Announcement !
Please do check the following link:

Assignment One:

https://forms.office.com/r/kQk5iLRXk5

Please note that this is a teamwork task and so the

assignment must be solved in groups (count of 5
students per group)

• Only online submission will be accepted.

• Due date to submit: Tuesday, 15th November at

10:00 pm .