Liquidity of Short-Term Assets - Related Debt-Paying Ability
Liquidity of Short-Term Assets - Related Debt-Paying Ability
Liquidity of Short-Term Assets - Related Debt-Paying Ability
Session 5
Acknowledgement
Example:
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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
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product or service or otherwise on a password-protected website for classroom use.
Operating Cycle
• 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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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
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product or service or otherwise on a password-protected website for classroom use.
Current Assets: Cash—Continued
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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
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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
• 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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product or service or otherwise on a password-protected website for classroom use.
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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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
• Liquidity measures
– Number of days’ sales in receivables
– Accounts receivable turnover
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product or service or otherwise on a password-protected website for classroom use.
Days’ Sales in Receivables
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product or service or otherwise on a password-protected website for classroom use.
Accounts Receivable Turnover
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product or service or otherwise on a password-protected website for classroom use.
Accounts Receivable Turnover in Days
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product or service or otherwise on a password-protected website for classroom use.
Current Assets: Inventories
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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)
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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
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product or service or otherwise on a password-protected website for classroom use.
FIFO Cost Flow Assumption
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product or service or otherwise on a password-protected website for classroom use.
LIFO Cost Flow Assumption
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product or service or otherwise on a password-protected website for classroom use.
Average Cost
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product or service or otherwise on a password-protected website for classroom use.
Cost Flow Assumption Example
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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
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product or service or otherwise on a password-protected website for classroom use.
Analysis Problems and Inventory
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product or service or otherwise on a password-protected website for classroom use.
Impact on Financial Statements
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product or service or otherwise on a password-protected website for classroom use.
Liquidity of Inventory
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product or service or otherwise on a password-protected website for classroom use.
Days’ Sales in Inventory
Ending Inventory
Days’ Sales in Inventory
Cost of Goods Sold 365
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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
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product or service or otherwise on a password-protected website for classroom use.
Inventory Turnover
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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
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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
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product or service or otherwise on a password-protected website for classroom use.
Current Assets: Operating Cycle
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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
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product or service or otherwise on a password-protected website for classroom use.
Current Assets: Other
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product or service or otherwise on a password-protected website for classroom use.
Current Liabilities
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product or service or otherwise on a password-protected website for classroom use.
Liquidity Ratios
Cash Equivalents
+ Marketable Securities
+ Net Receivables
Acid-Test (Quick) Ratio =
Current Liabilities
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product or service or otherwise on a password-protected website for classroom use.
Working Capital
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product or service or otherwise on a password-protected website for classroom use.
Current Ratio
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product or service or otherwise on a password-protected website for classroom use.
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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product or service or otherwise on a password-protected website for classroom use.
Sales to Working Capital