Liquidity of Short-Term Assets - Related Debt-Paying Ability

Course : Business Valuation and Analysis
Effective Period : Februari 2018
Liquidity of Short-Term Assets;

Related Debt-Paying ability
Session 5
Acknowledgement
If you are using PowerPoint from textbook,

please use this slide to give information about
the source of the slides.
Example:
These slides have been adapted from:
Gibson, Charles H. (2013). Financial Statement Analysis. 13 th

Edition, South Western Cengage Learning. ISBN: 9781133189404
Chapter 6
Learning Outcome
• LO 2: Perform and implement accounting analysis

and financial analysis
Chapte
r6
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
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
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
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
Current Assets: Marketable Securities
• 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
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
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
• Impairment—Accrue (allowance method)

– Based on estimate of receivables’ realizable value
– Set up allowance
• Expense recognized on income statement
• Asset reduced by “Allowance for Doubtful Debts” account
– Charge-off of a specific receivable
• Reduces accounts receivable and allowance for doubtful
accounts
• No impact on income statement or net assets
• 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
• 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
• 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
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
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
• 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 in which a
material amount of the receivables is sold
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
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
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
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)
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
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
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
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
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 $ 4,400 800 units of ending
01-Jul Purchase 300 9.00 2,700
inventory are valued
01-Mar Purchase 100 7.00 700
Ending inventory 800 $ 7,800 at the most recent
Cost of Goods Sold $ 8,900 costs
LIFO
01-Jan Beginning inventory 200 $ 6.00 $ 1,200
01-Mar Purchase 600 7.00 4,200
800 units of ending
Ending inventory 800 $ 5,400 inventory are valued
Cost of goods sold $ 11,300 at the oldest costs
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
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
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
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
Liquidity of Inventory
• Days’ sales in inventory

• Inventory turnover in times per year
• Inventory turnover in days
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
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
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
Cost of Goods Sold
Inventory Turnover =
Average Inventory
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
Inventory Turnover in Days
Average Inventory
Inventory Turnover in Days =
Cost of Goods Sold 365
365
Inventory Turnover per Year =
Inventory Turnover in Days
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
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
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
– 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
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
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
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
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
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
Cash Equivalents + Marketable Securities

Cash Ratio =
Current Liabilities
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
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

Liquidity of Short-Term Assets - Related Debt-Paying Ability

Caricato da

Informazioni sul documento

Titolo originale

Copyright

Formati disponibili

Condividi questo documento

Condividi o incorpora il documento

Opzioni di condivisione

Hai trovato utile questo documento?

Questo contenuto è inappropriato?

Copyright:

Formati disponibili

Liquidity of Short-Term Assets - Related Debt-Paying Ability

Caricato da

Copyright:

Formati disponibili

Course : Business Valuation and Analysis

Effective Period : Februari 2018

Liquidity of Short-Term Assets;

If you are using PowerPoint from textbook,

These slides have been adapted from:

Gibson, Charles H. (2013). Financial Statement Analysis. 13 th

• LO 2: Perform and implement accounting analysis

• Current assets (1) are in the form of cash, (2)

• The time period between the acquisition of

Purchase inventory Purchase material

• The cash account on the balance sheet is

• To qualify as a marketable security

• Claims to future cash inflows

• Impairment—Accrue (allowance method)

• Should mirror the company’s credit terms

• Causes for overstatement

• Indicates the liquidity of receivables

• Similar to days’ sales in receivables except

• Held for sale in the ordinary course of

• First inventory acquired is the first sold

• Cost of latest acquired goods are matched

• Determines a midpoint to calculate cost

Number Cost per Total Cost of

Ending inventory (800 × $7.95) = $6,360

• If LIFO method is being used, short-term debt-

• Cash flow is higher when LIFO is used for tax

• Cost flow assumptions use historical data

• Days’ sales in inventory

• Indicates the length of time needed to sell all

• Indicates the liquidity of inventory

• The period between acquisition of goods and

• Subject to potential understatement from

• Will be realized in cash or conserve the use of

• Obligations whose liquidation is reasonably

Working Capital = Current Assets  Current Liabilities

• Indicates short-run solvency of a business

• Determines short-term debt-paying ability

• Measures the immediate liquidity of the firm

Cash Equivalents + Marketable Securities

• Measures the turnover of working capital per

• Liquidity is better than indicated by financial

Potrebbero piacerti anche