Chapter - 6.ppt...........................
- 1. COPYRIGHT ©2011 South-Western, a part of Cengage Learning. Liquidity of Short-Term Assets; Related Debt-Paying Ability Chapter 6
- 2. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #2 Current Assets • Current assets – In the form of cash or will be realized in cash or conserve the use of cash within the operating cycle, or one year, whichever is longer • Typical examples – Cash – Marketable securities – Receivables – Inventories – Prepayments
- 3. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #3 Operating Cycle The time period between the acquisition of goods and the final cash realization from sales Purchase inventory Cash sale to customer Purchase material Produce finished product Sell to customer on credit Collect amount due from customer Retail and Wholesale Manufacturing
- 4. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #4 Current Assets: Cash • Unrestricted – Available to pay creditors – Report as current asset • Restricted – May report as current but disclose restrictions – Eliminate cash and related current liability when measuring short-term debt-paying ability
- 5. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #5 Current Assets: Cash (cont’d) • Compensating balance – A portion of loan proceeds required to be retained on deposit – Increases effective interest rate – Against current liability • Part of current assets; disclosure – Against noncurrent liability • Reported as noncurrent asset
- 6. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #6 Current Assets: Marketable Securities • Debt and equity securities • Readily marketable – Managerial intent to convert to cash within the year or the operating cycle, whichever is longer • Carried at fair value • Analysis: – Reclassify continuing investments as noncurrent
- 7. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #7 Current Assets: Receivables • Claims to future cash inflows • Arise from sales to customers – Trade (account) receivables – Notes receivable • Other current receivables
- 8. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #8 Current Assets: Receivables (cont’d) • Valuation – Ignore cost of fund use for delayed collection – Assume rate of interest is reasonable • Notes that are noninterest-bearing carry an unreasonable rate, or are for an amount different from value of transaction are recorded at present value – Impairment • Uncollectibility • Allowed discounts • Allowances given • Returns
- 9. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #9 Current Assets: Receivables (cont’d) • Impairment: Accrue (allowance method) – Based on estimate of receivables’ realizable value – Set up allowance • Expense recognized on income statement • Asset reduced by contra account “Allowance” – Expense on income statement before deducted on tax return – Charge-off of a specific receivable • Reduces accounts receivable and allowance for doubtful accounts • No impact on financial income or net assets • Deductible event for income taxes
- 10. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #10 Current Assets: Receivables (cont’d) • 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
- 11. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #11 Current Assets: Receivables (cont’d) • 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
- 12. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #12 Current Assets: Receivables (cont’d) • Customer concentration – May impair the quality of receivables if a large portion of receivables is from a few customers • Liquidity – Number of days’ sales in receivables – Accounts receivable turnover
- 13. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #13 Days’ Sales in Receivables • Should mirror the company’s credit terms • Reading reflects end-of-year status of receivables – Use of the natural business year (lower sales at year-end) can understate result • Compare – Firm data for several years – Other industry firms and industry averages Gross Receivables Net Sales 365
- 14. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #14 Days’ Sales in Receivables (cont’d) • Causes for overstatement – Sales volume expands materially late in the year – Receivables are uncollectible and should have been written off – The company seasonally dates invoices – A large portion of 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 – The company has a factoring arrangement in which a material amount of the receivables is sold to an outside party
- 15. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #15 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 – Internal analysis: use monthly or weekly amounts – External analysis: use quarterly data Net Sales Average Gross Receivables
- 16. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #16 Accounts Receivable Turnover in Days • Similar to Number of Days’ Sales in Receivables except average receivables are used • Should reflect firm’s credit and collection policies Average Gross Receivables Net Sales 365
- 17. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #17 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
- 18. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #18 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 • Periodic – Periodic physical inventories to determine quantity – Attach costs to ending inventory based on selected cost flow assumption(s)
- 19. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #19 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
- 20. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #20 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
- 21. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #21 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
- 22. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #22 Cost Flow Assumption Example Date Description Number of Units Cost per Unit Total Cost 1-Jan Beginning inventory 200 6.00 $ 1,200 $ 1-Mar Purchase 1,200 7.00 8,400 1-Jul Purchase 300 9.00 2,700 1-Oct Purchase 400 11.00 4,400 2,100 16,700 $ FIFO 1-Oct Purchase 400 11.00 $ 4,400 $ 1-Jul Purchase 300 9.00 2,700 1-Mar Purchase 100 7.00 700 Ending inventory 800 7,800 $ Cost of Goods Sold 8,900 LIFO 1-Jan Beginning inventory 200 6.00 $ 1,200 $ 1-Mar Purchase 600 7.00 4,200 Ending inventory 800 5,400 $ Cost of goods sold 11,300 $ 800 units of ending inventory are valued at the most recent costs. 800 units of ending inventory are valued at the oldest costs. 2,100 units available for sale.
- 23. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #23 Cost Flow Assumption Example Date Description Number of Units Cost per Unit Total Cost 1-Jan Beginning inventory 200 6.00 $ 1,200 $ 1-Mar Purchase 1,200 7.00 8,400 1-Jul Purchase 300 9.00 2,700 1-Oct Purchase 400 11.00 4,400 2,100 16,700 $ 800 units of ending inventory are valued at average unit cost. Total Cost $16,700 = $7.95 Total Units 2,100 Ending inventory (800 × $7.95) = $6,360 Cost of goods sold ($16,700 – $6,360) = $10,340 2,100 units available for sale. Average Cost
- 24. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #24 Analysis Problems and Inventory • Short-term debt-paying ability is understated – Understatement is reduced by reported operating expenses that reduce gross profit to net income – Replacement cost exceeds LIFO or FIFO cost of goods sold
- 25. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #25 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 • LIFO reserve – Measures the spread between LIFO and FIFO inventory value – Discloses the approximate FIFO inventory value • FIFO inventory is closer to replacement value of the asset
- 26. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #26 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 • Definitions of market – Replacement cost – Net realizable value
- 27. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #27 Liquidity of Inventory • Number of days’ sales in inventory • Inventory turnover in times per year • Inventory turnover in days
- 28. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #28 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 • Implications of extremes – High: excessive inventory for sales activity – Low: inventory shortage and lost sales Ending Inventory Cost of Goods Sold 365
- 29. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #29 Inventory Turnover • Indicates the liquidity of inventory • Determining average inventory – End of year and beginning of year base points for average mask seasonal fluctuations – Internal analysis: use monthly or weekly amounts – External analysis: use quarterly data Cost of Goods Sold Average Inventory
- 30. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #30 Inventory Turnover 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
- 31. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #31 Inventory Turnover in Days Average Inventory Cost of Goods Sold 365 Inventory Turnover per Year 365 Inventory Turnover in Days
- 32. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #32 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 – Use of a natural business year – Averages are computed on beginning-of-year and end-of-year data
- 33. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #33 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
- 34. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #34 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
- 35. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #35 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
- 36. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #36 Working Capital • Subject to understatement if certain assets are understated (i.e., LIFO inventory) • Longitudinal comparison appropriate • Inter-firm comparison is of no value Current Assets – Current Liabilities = Working Capital
- 37. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #37 Current Ratio Current Assets Current Liabilities Acid-Test (Quick) Ratios Current Assets - Inventory Current Liabilities Cash Equivalents + Marketable Securities + Net Receivables Current Liabilities
- 38. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #38 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
- 39. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #39 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
- 40. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #40 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 inventory and receivables – Firms that are highly speculative Cash Equivalents + Marketable Securities Current Liabilities
- 41. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #41 Sales to 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 Sales Average Working Capital
- 42. Copyright 2011 South-Western, a part of Cengage Learning. All rights reserved. Chapter 6, Slide #42 Other Liquidity Considerations • Liquidity is better than indicated by financial statements – Unused bank credit lines – Noncurrent assets that can be converted to cash quickly • Liquidity is weaker than indicated by financial statements – Co-signer on debt of another entity – Subject to recourse obligation on discounted receivables – Significant contingent (unaccrued) liabilities