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HUANGHUAI UNIVERSITY & BANGOR UNIVERSITY Chapter 6

HUANGHUAI UNIVERSITY & BANGOR UNIVERSITY Chapter 6 Liquidity of Short-Term Assets; Related Debt-Paying Ability DR. AZIZ JAAFAR. Current Assets. Current assets

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HUANGHUAI UNIVERSITY & BANGOR UNIVERSITY Chapter 6

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  1. HUANGHUAI UNIVERSITY & BANGOR UNIVERSITY Chapter 6 Liquidity of Short-Term Assets; RelatedDebt-Paying Ability DR. AZIZ JAAFAR

  2. Current Assets • Current assets • In the form of cash orwill be realized in cash orconserve the use of cash within the operating cycle, or one year, whichever is longer • Typical examples • Cash – Marketable securities • Receivables – Inventories • Prepayments

  3. Operating Cycle The time period between the acquisition of goods and the final cash realization from sales Retail and Wholesale Manufacturing Purchase inventory Cash sale to customer Purchase material Produce finished product Sell to customer on credit Collect amount due from customer

  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. 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

  6. Current Assets: Receivables • Claims to future cash inflows • Arise from sales to customers • Trade (account) receivables • Notes receivable • Other current receivables

  7. 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

  8. 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

  9. 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

  10. 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

  11. 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

  12. 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

  13. Liquidity of Inventory • Number of days’ sales in inventory • Inventory turnover in times per year • Inventory turnover in days

  14. 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

  15. 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

  16. 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

  17. Current Assets: Operating Cycle • The time period between acquisition of goods and the final cash realization from sales • 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

  18. 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

  19. 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

  20. Current Ratio Acid-Test (Quick) Ratios

  21. 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

  22. 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

  23. 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

  24. 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

  25. 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

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