Chapter
Liquidity of Short-Term
Assets; Related
Debt-Paying Ability
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
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
• 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
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
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
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 in Days
Average Inventory
Inventory Turnover in Days =
Cost of Goods Sold 365
365
Inventory Turnover per Year =
Inventory Turnover in Days
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