Lecture 4 Liquidity With Comments PDF

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ...

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Chapter 4 Liquidity of Short-Term Assets; Related Debt-Paying Ability © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Operating Cycle The time period between the acquisition of goods and the final cash realization from sales Retail and Wholesale Manufacturing Purchase inventory Purchase material Cash sale to customer Produce finished product Sell to customer on credit Collect amount due from customer © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 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: Cash Unrestricted – Available for deposit or to pay creditors – Reported as current asset Restricted === not available for all transactions – Maybe reported as current but must disclose restrictions – Eliminate cash and related current liability when measuring short-term debt-paying ability © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 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: 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 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: 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2. Current Assets: Marketable Securities  securities (shares, bonds…) held for the short term, to be sold quickly To qualify as a marketable security – The investment must be readily marketable – Intention to convert it to cash within the year or the operating cycle, whichever is longer Examples – Treasury bills, short-term notes of corporations, government bonds, corporate bonds, preferred stock, and common stock Debt and equity securities are carried at fair value © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 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: Receivables when the firm made a selling operation on credit 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 === write off the receivable (eliminate from accounting book) © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 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: 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 (decrease in value) Uncollectibility Discounts allowed Allowances given Sales returns © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 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: Receivables— Continued Impairment—Accrue (allowance method) – Based on estimate of receivables’ realizable value – Set up allowance (provision) Expense recognized on income statement Asset reduced by “Allowance for Doubtful Debts” account © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 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: Receivables— Continued Trade receivables ===== full amount paid at once – Typically collected within 30 days Installment receivables = payment in multiple parts rather than paying the full amount at once. – 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 === more risk + more time to be paid © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 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: Receivables— Continued Customer concentration – May impair the quality of receivables if a large portion of receivables is from a few customers = situation with high risk Liquidity measures (RATIOS) – Number of days’ sales in receivables – Accounts receivable turnover © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Days’ Sales in Receivables Should mirror the company’s credit terms Indicates the length of time that the receivables have been outstanding = number of days to be paid by clients – Use of the natural business year (lower sales at year- end) can understate = firms prefer LOWER “days sales in receivable” ratio = it indicates that the clients are paying quickly, GROSS receivable = it is receivable before the allowance Gross Receivables Days' Sales in Receivables = Compare Net Sales 365 – Firm’s data for several years – Other firms in the industry and industry averages © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Days’ Sales in Receivables— Continued Causes for overstatement – Sales volume expands materially late in the year – Uncollectibles should have been written off – A company seasonally dates invoices – Receivables are on the installment basis = stay more time in the balance sheet so inflate the receivable Causes for understatement – Sales volume decreases materially late in the year – A material amount of sales are on a cash basis – A company has a factoring arrangement with a bank in which a material amount of the receivables is sold © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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  Indicate the number of times, the receivables are paid, per year === firms prefer a higher ratio indicating faster payment. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Accounts Receivable Turnover in Days Similar to days’ sales in receivables except average gross receivables are used Should reflect firm’s credit and collection policies Average Gross Receivables Average Receivable Turnover in Days = Net Sales 365 Firms prefer a lower ratio, indicating less days to be paid. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  You can do Exercise 5 Now © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 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: 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 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: 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) © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LIFO Cost Flow Assumption Cost of latest acquired goods are matched against sales revenue Ending inventory contains the oldest costs – Inventory valuation can be based on costs that are years or decades old © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  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 01-Jul Purchase 300 9.00 2,700 2,100 units 01-Oct Purchase 400 11.00 4,400 available for sale 2,100 $ 16,700 FIFO 01-Oct Purchase 400 $ 11.00 $ 4,400 1300 units will be 01-Jul Purchase 300 9.00 2,700 sold. 800 units of 01-Mar Purchase 100 7.00 700 ending inventory are Ending inventory 800 $ 7,800 valued at the most Cost of Goods Sold $ 8,900 recent costs 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  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 01-Oct Purchase 400 11.00 4,400 800 units of ending 2,100 $ 16,700 inventory are valued at average unit cost Total Cost $16,700 Average unit cost =  $7.95 Total Units 2,100 Ending inventory (800 × $7.95) = $6,360 Cost of goods sold ($16,700 − $6,360) = $10,340 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Analysis Problems and Inventory If LIFO method is being used, short-term debt- paying ability is understated © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 LIFO reserve – Measures the spread between LIFO and FIFO inventory value – Discloses the approximate FIFO inventory value © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Liquidity of Inventory Days’ sales in inventory Inventory turnover in times per year Inventory turnover in days © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 === Firms prefer lower ratios indicating that the firm can sell the inventory quickly. (Eg: merchandise staying for a long period in the warehouse is a bad sign) Ending Inventory Days’ Sales in Inventory  Cost of Goods Sold 365 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain 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 A high ratio indicates a high turnover of inventory so firms prefer higher ratios indicating dynamism in the selling activity. Cost of Goods Sold Inventory Turnover = Average Inventory © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Inventory Turnover in Days Average Inventory Inventory Turnover in Days = Cost of Goods Sold 365 365 Inventory Turnover per Year = Inventory Turnover in Days © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  You can do exercise 6 Now © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 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: 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 Subject to potential understatement from understatement of turnover measures – Use of LIFO inventory – Use of a natural business year – Averages are computed based on beginning-of-year and end-of-year data © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 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: 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for 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: 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Working Capital= CA – CL Indicates short-run solvency of a business = it is a famous measure of liquidity. == It should be positive (current assets > current liabilities). If negative = Unfavorable ratio Subject to understatement if certain assets are understated (i.e., LIFO inventory) Longitudinal comparison appropriate= compare with the previous years , what is the trend Inter-firm comparison is of no value because of their size differences == Not useful to compare firms © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Current Ratio, also a measure of liquidity = Current asset/ current liabilities 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. if lower than 2, it is an unfavourable ratio – Decreased current ratio indicates lower liquidity – Industry averages provide contextual benchmarks Considerations – Quality of inventory and receivables – Inventory cost flow assumptions © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Acid-Test (Quick) Ratio = (Current assets – Inv )/ Current liabilities Measures the immediate liquidity of the firm because inventory is removed from the calculation 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain – product or service or otherwise on a password-protected website for classroom use. Cash Ratio Extremely conservative (narrow approach of the liquidity) – 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 Cash Equivalents + Marketable Securities Cash Ratio = Current Liabilities © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.