Chapter 6
Liquidity of Short-Term
Assets; Related
Debt-Paying Ability
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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
– Receivables
– Prepayments
– Marketable securities
– Inventories
Chapter 6, Slide #2
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 6, Slide #3
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 6, Slide #4
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 6, Slide #5
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 6, Slide #6
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Current Assets: Receivables
• Claims to future cash inflows
• Arise from sales to customers
– Trade (account) receivables
– Notes receivable
• Other current receivables
Chapter 6, Slide #7
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 6, Slide #8
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 6, Slide #9
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 6, Slide #10
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 6, Slide #11
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 6, Slide #12
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Days’ Sales in Receivables
Gross Receivables
 Net Sales 


365


• 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
Chapter 6, Slide #13
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 6, Slide #14
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Accounts Receivable Turnover
Net Sales
Average Gross Receivables
• 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
Chapter 6, Slide #15
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Accounts Receivable Turnover in Days
Average Gross Receivables
 Net Sales 


365


• Similar to Number of Days’ Sales in
Receivables except average receivables are
used
• Should reflect firm’s credit and collection
policies
Chapter 6, Slide #16
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 6, Slide #17
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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)
Chapter 6, Slide #18
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 6, Slide #19
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 6, Slide #20
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 6, Slide #21
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Cost Flow Assumption Example
Cost
Date
Description
1-Jan
1-Mar
1-Jul
1-Oct
Beginning inventory
Purchase
Purchase
Purchase
FIFO
1-Oct Purchase
1-Jul Purchase
1-Mar Purchase
Ending inventory
Number
per
Total
of Units
Unit
Cost
200 $ 6.00 $ 1,200
1,200
7.00
8,400
300
9.00
2,700
400
11.00
4,400
2,100
$16,700
400 $11.00 $ 4,400
300
9.00
2,700
100
7.00
700
800
$ 7,800
Cost of Goods Sold
8,900
LIFO
1-Jan Beginning inventory
1-Mar Purchase
Ending inventory
200 $ 6.00 $ 1,200
600
7.00
4,200
800
$ 5,400
Cost of goods sold
$11,300
2,100 units
available for
sale.
800 units of
ending inventory
are valued at the
most recent
costs.
800 units of
ending inventory
are valued at the
oldest costs.
Chapter 6, Slide #22
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Cost Flow Assumption Example
Average Cost
Date
Description
1-Jan
1-Mar
1-Jul
1-Oct
Beginning inventory
Purchase
Purchase
Purchase
Cost
Number
per
of Units
Unit
Total Cost
200 $ 6.00 $ 1,200
1,200
7.00
8,400
300
9.00
2,700
400 11.00
4,400
2,100
$ 16,700
2,100 units
available for
sale.
Total Cost
$16,700
=
 $7.95
Total Units
2,100
Ending inventory (800 × $7.95) =
Cost of goods sold ($16,700 – $6,360) =
$6,360
$10,340
Chapter 6, Slide #23
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
800 units of
ending inventory
are valued at
average unit
cost.
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
Chapter 6, Slide #24
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 6, Slide #25
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 6, Slide #26
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Liquidity of Inventory
• Number of days’ sales in inventory
• Inventory turnover in times per year
• Inventory turnover in days
Chapter 6, Slide #27
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Days’ Sales in Inventory
Ending Inventory
 Cost of Goods Sold 


365


• 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
Chapter 6, Slide #28
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Inventory Turnover
Cost of Goods Sold
Average Inventory
• 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
Chapter 6, Slide #29
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 6, Slide #30
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Inventory
Turnover in Days
Average Inventory
 Cost of Goods Sold 


365


Inventory Turnover
per Year
365
Inventory Turnover
in Days
Chapter 6, Slide #31
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 6, Slide #32
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 6, Slide #33
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 6, Slide #34
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 6, Slide #35
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Working Capital
–
=
Current Assets
Current Liabilities
Working Capital
• Subject to understatement if certain assets are
understated (i.e., LIFO inventory)
• Longitudinal comparison appropriate
• Inter-firm comparison is of no value
Chapter 6, Slide #36
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Current Ratio
Current Assets
Current Liabilities
Acid-Test (Quick)
Ratios
Current Assets - Inventory
Current Liabilities
 Cash Equivalents

 + Marketable Securities 
 + Net Receivables



Current Liabilities
Chapter 6, Slide #37
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 6, Slide #38
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 6, Slide #39
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Cash Ratio
Cash Equivalents + Marketable Securities
Current Liabilities
• 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
Chapter 6, Slide #40
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Sales to Working Capital
Sales
Average 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
Chapter 6, Slide #41
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 6, Slide #42
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.