Chapter 6

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

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
 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

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
Number per Total
Date Description of Units Unit Cost
1-Jan Beginning inventory 200 $ 6.00 $ 1,200
1-Mar Purchase 1,200 7.00 8,400 2,100 units
1-Jul Purchase 300 9.00 2,700 available for
1-Oct Purchase 400 11.00 4,400 sale.
2,100 $16,700
FIFO
1-Oct Purchase 400 $11.00 $ 4,400 800 units of
1-Jul Purchase 300 9.00 2,700 ending inventory
1-Mar Purchase 100 7.00 700
are valued at the
Ending inventory 800 $ 7,800
most recent
Cost of Goods Sold 8,900 costs.
LIFO
1-Jan Beginning inventory 200 $ 6.00 $ 1,200 800 units of
1-Mar Purchase 600 7.00 4,200 ending inventory
Ending inventory 800 $ 5,400
are valued at the
Cost of goods sold $11,300 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
Cost
Average Cost
Number per
Date Description of Units Unit Total Cost
1-Jan Beginning inventory 200 $ 6.00 $ 1,200
1-Mar Purchase 1,200 7.00 8,400 2,100 units
1-Jul Purchase 300 9.00 2,700 available for
1-Oct Purchase 400 11.00 4,400 sale.
2,100 $ 16,700

Total Cost $16,700

=  $7.95
Total Units 2,100
800 units of
Ending inventory (800 × $7.95) = $6,360 ending inventory
are valued at
Cost of goods sold ($16,700 – $6,360) = $10,340
average unit
cost.

Chapter 6, Slide #23

Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
 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 Inventory
Turnover in Days Turnover per Year

Average Inventory 365

 Cost of Goods Sold  Inventory Turnover
 
 365  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.
 Acid-Test (Quick)
Current Ratio
Ratios
Current Assets Current Assets - Inventory
Current Liabilities 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.