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FSA - Ch06 - Liquidity of Short-Term Assets Related Debt-Paying Ability
FSA - Ch06 - Liquidity of Short-Term Assets Related Debt-Paying Ability
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Chapter
6
Liquidity of Short-Term
Assets; Related
Debt-Paying Ability
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use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
Current Assets
• 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
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Operating Cycle
• The time period between the acquisition of
goods and the final cash realization from sales
Retail and Wholesale Manufacturing
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Current Assets: Cash
• 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
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Current Assets: Cash—Continued
• 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
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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
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product or service or otherwise on a password-protected website for classroom use.
Current Assets: Marketable Securities
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product or service or otherwise on a password-protected website for classroom use.
Current Assets: Receivables
• 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
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Current Assets: Receivables—Continued
• 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
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product or service or otherwise on a password-protected website for classroom use.
Current Assets: Receivables—Continued
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product or service or otherwise on a password-protected website for classroom use.
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
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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
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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
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Days’ Sales in Receivables
• 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
Gross Receivables
Days' Sales in Receivables =
Net Sales 365
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Days’ Sales in Receivables—Continued
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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
– For internal analysis, use monthly or weekly amounts
– For external analysis, use quarterly data
Net Sales
Accounts Receivable Turnover =
Average Gross Receivables
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Accounts Receivable Turnover in Days
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Current Assets: Inventories
• 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
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Current Assets: Inventories—Continued
• 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)
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Inventory Cost
• 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
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FIFO Cost Flow Assumption
• 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
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LIFO 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 is banned under IFRS
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Average Cost
• 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
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Cost Flow Assumption Example
Number Cost per Total Cost of
Date Description of Units Unit Cost Goods Sold
01-Jan Beginning inventory 200 $ 6.00 $ 1,200
01-Mar Purchase 1,200 7.00 8,400
2,100 units
01-Jul Purchase 300 9.00 2,700
available for sale
01-Oct Purchase 400 11.00 4,400
2,100 $ 16,700
FIFO
01-Oct Purchase 400 $ 11.00 $ 4,400 800 units of ending
01-Jul Purchase 300 9.00 2,700 inventory are valued
01-Mar Purchase 100 7.00 700 at the most recent
Ending inventory 800 $ 7,800 costs
Cost of Goods Sold $ 8,900
LIFO
01-Jan Beginning inventory 200 $ 6.00 $ 1,200
800 units of ending
01-Mar Purchase 600 7.00 4,200
inventory are valued
Ending inventory 800 $ 5,400
at the oldest costs
Cost of goods sold $ 11,300
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Cost Flow Assumption Example
AVERAGE COST
Number of Cost per
Date Description Units Unit Total Cost
01-Jan Beginning inventory 200 $ 6.00 $ 1,200
2,100 units available for
01-Mar Purchase 1,200 7.00 8,400 sale
01-Jul Purchase 300 9.00 2,700
800 units of ending
01-Oct Purchase 400 11.00 4,400
inventory are valued at
2,100 $ 16,700
average unit cost
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Analysis Problems and Inventory
• 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
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Impact on Financial Statements
• 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
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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
• Market is defined in terms of
– Replacement cost
– Net realizable value
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Liquidity of Inventory
• Days’ sales in inventory
• Inventory turnover in times per year
• Inventory turnover in days
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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
Ending Inventory
Days’ Sales in Inventory
Cost of Goods Sold 365
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Days’ Sales in Inventory—Continued
• 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
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product or service or otherwise on a password-protected website for classroom use.
Inventory Turnover
• 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
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Inventory Turnover—Continued
Comparison Issues
• 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
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Inventory Turnover in Days
Average Inventory
Inventory Turnover in Days =
Cost of Goods Sold 365
365
Inventory Turnover per Year =
Inventory Turnover in Days
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Current Assets: Operating Cycle
• The period between acquisition of goods and the
final cash realization from sales
Operating Cycle = Accounts Receivable Turnover in Days + Inventory Turnover in Days
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Current Assets: Prepayments
• 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
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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
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product or service or otherwise on a password-protected website for classroom use.
Current Liabilities
• 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
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Liquidity Ratios
Working Capital = Current Assets Current Liabilities
Current Assets
Current Ratio =
Current Liabilities
Current Assets Inventory
Acid-Test (Quick) Ratio =
Current Liabilities
Cash Equivalents
+ Marketable Securities
+ Net Receivables
Acid-Test (Quick) Ratio =
Current Liabilities
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Working Capital
• 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
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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
• 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
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Acid-Test (Quick) 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
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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 inventories and
receivables
– Firms that are highly speculative
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Sales to Working Capital
• 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
Sales to Working Capital =
Average Working Capital
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Other Liquidity Considerations
• 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
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