An entity’s ability to maintain its short-term debt-paying ability is important to all users of financial statements.

If the entity cannot maintain a short-term debt-paying ability, it will not be able to maintain a long-term debt-
paying ability, nor will it be able to satisfy its stockholders. Even a very profitable entity will find itself bankrupt if
it fails to meet its obligations to short-term creditors.

The ability to pay current obligations when due is also related to the cash-generating ability of the firm.

When analyzing the short-term debt-paying ability of the firm, we find a close relationship between the current
assets and the current liabilities. Generally, the current liabilities will be paid with cash generated from the
current assets.

This chapter suggests procedures for analyzing short-term assets and the short-term debt-paying ability of an
entity. The procedures require an understanding of current assets, current liabilities, and the notes to financial
statements.

This chapter also includes a detailed discussion of four very important assets—cash, marketable securities,
accounts receivable, and inventory. Accounts receivable and inven- tory, two critical assets, often substantially
influence the liquidity and profitability of a firm.

Current Assets, Current Liabilities, and the Operating Cycle

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 material
Purchase inventory
Produce finished product
Cash sale to customer
Sell to customer on credit

Collect amount due from customer

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 Cash

> Cash could be

• Unrestricted
– Available for deposit or to pay creditors
– Reported as current asset
• Restricted
– Maybe reported as current but must disclose restrictions
– Eliminate this kind of cash and related current liability when measuring short-
term debt-paying ability

> Compensating balance

• Is a minimum deposit that must be maintained in a bank account by a borrower.
• The requirement for a compensating balance is most common with corporate rather
than individual loans. The borrower cannot use the money but is required to disclose
it in the borrower’s notes attached to its financial statements.

• For the borrower, the compensating balance is a mixed blessing. The loan generally
will come at a lower rate of interest. However, the borrower must pay interest on the
full amount of the loan, including the balance that may not be spent.

• Compensating balances are generally reported on financial statements as restricted

cash.

– Against short-term borrowings

• Separately stated in the current asset section or notes
– Against long-term borrowings
• Separately stated as noncurrent assets under either investments or
other assets

> 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

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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
• Exhibit 6-1 presents the marketable securities on the 2011 annual report of Nike, Inc.
It discloses the detail of the marketable securities account. Many companies do not
disclose this detail.

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 Receivables

• Claims to future cash inflows

– Accounts receivables
– Notes receivables

The primary claim that most entities have comes from the selling of
merchandise or services on account to customers, referred to as trade
receivables, with the customer promising to pay within a limited period of time.

Question. What are the differences between A/R and N/R? you can find the answer in
page 226.

Other claims (receivables) may be from sources such as loans to employees or

a federal tax refund.

• Valuation problems
– The entity incurs costs for the use of the funds, until receivables are collected

The valuation problem from waiting to collect is ignored in the valuation of

receivables and of notes classified as current assets because of the short
waiting period and the immaterial differ- ence in value. The waiting period
problem is not ignored if the receivable or note is long term and classified
as an investment.

– Collection might not be made

Question: What is the difference between the direct write off method and allowance
method? You can find the answer in pages 226&227

• Liquidity measures
– Number of days’ sales in receivables at the end of the accounting period.
– Accounts receivable turnover. It is used to show the number of times per year
receivables turn over or to show how many days on the average it takes to
collect the receivables.

Days’ Sales in Receivables

The number of days’ sales in receivables relates the amount of the accounts receivable to the
average daily sales on account. For this computation, the accounts receivable amount should
include trade notes receivable. Other receivables not related to sales on account should not
be included in this computation.

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The days’ sales in receivables indicates the length of time that the receivables have been
outstanding at the end of the year.

The increase in days’ sales in receivables from 52.29 days at the end of 2010 to 56.19 days at
the end of 2011 indicates a negative trend in the control of receivables.

An internal analyst compares days’ sales in receivables with the company’s credit terms as an
indication of how efficiently the company manages its receivables. For example, if the credit
term is 30 days, days’ sales in receivables should not be materially over 30 days. If days’ sales
in receivables are materially more than the credit terms, the company has a collection
problem. An effort should be made to keep the days’ sales in receivables close to the credit
terms.

Consider the effect on the quality of receivables from a change in the credit terms. Shortening
the credit terms indicates that there will be less risk in the collection of future receivables,
and lengthening the credit terms indicates a greater risk. Credit term information is readily
available for internal analysis and may be available in notes.

Accounts Receivable Turnover

Indicates the liquidity of the receivables.

• The accounts receivable turnover ratio is an accounting measure used to quantify

how efficiently a company is in collecting receivables from its clients.
• The ratio also measures the times that receivables are converted to cash during a
certain time period.

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 • A high ratio may indicate that corporate collection practices are efficient with quality
customers who pay their debts quickly.
• A low ratio could be the result of inefficient collection processes, inadequate credit
policies, or customers who are not financially viable or creditworthy.
• Investors should be mindful that some companies use total sales rather than net sales
to calculate their ratios, which may inflate the results.

Compute the accounts receivable turnover measured in times per year as follows:

Average gross receivables = (Beg. Gross receivals + End. Gross receivables)/2

The turnover of receivables increased between 2010 and 2011 from 6.69 times per year to
7.03 times per year. For Nike, this would be a positive trend.

Accounts Receivable Turnover in Days

The accounts receivable turnover can be expressed in terms of days instead of times per year.
Turnover in number of days also gives a comparison with the number of days’ sales in the
end- ing receivables. The accounts receivable turnover in days also results in an answer
directly related to the firm’s credit terms. Compute the accounts receivable turnover in days
as follows:

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This formula is the same as that for determining number of days’ sales in receivables, except
that the accounts receivable turnover in days is computed using the average gross
receivables. Exhibit 6-5 presents the computation for Nike at the end of 2011 and 2010.
Accounts receivable turnover in days decreased from 54.54 days in 2010 to 51.92 days in
2011. This would represent a positive trend.

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Answer

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 Inventories

– Inventory is often the most significant asset in determining the short-term debt-paying
ability of an entity.
– Often, the inventory account is more than half of the total current assets. Because of the
significance of invenories, a special effort should be made to analyze properly this
important area.
– 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

• Periodic and perpetual inventory systems

Perpetual
o A continuous record of physical quantities is maintained
o Inventory and cost of goods sold are updated as sales and purchases take
place
o Records are verified through physical inventory

Periodic
o Periodic physical counts to determine quantity
o Attach costs to ending inventory based on selected cost flow assumption(s)

Inventory cost

• Specific identification
– Tracking of specific cost normally impractical
– Exceptions to this are large and/or expensive items
– If specific costs are used, it is referred to as the specific identification method
• Cost flow assumptions
– FIFO (first-in, first-out)
– LIFO (last-in, first-out)
– Averaging

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 FIFO Cost Flow Assumption

• First inventory acquired is the first sold

• Cost of goods sold includes oldest costs
– Current costs are not matched against current revenue
– Inflates profits during a time of inflation
• Ending inventory reflects latest costs
– Approximates replacement cost
– Low turnover can distort the approximation of replacement cost

LIFO Cost Flow Assumption

• Cost of latest acquired goods are matched against sales revenue

– Improves the matching of current costs against current 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

Average cost

• Determines a midpoint to calculate cost

• Results in an inventory amount and a cost of goods sold amount somewhere
between FIFO and LIFO
• During times of inflation
– Inventory is more than LIFO and less than FIFO
– Cost of goods sold is less than LIFO and more than FIFO

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Example

A physical inventory count on December 31 indicates 800 units on hand.

Requirement:

a- Find the COGS and ENDING INVENTORY using FIFO, LIFO and Average cost assumptions.

C- Which method provides More realistic profit? Why?

Which method is better for the perspective of the statement of financial position? Why?

The Answer

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Analysis Problems and Inventory

• If LIFO method is being used, short-term debt-paying ability is understated

– Understatement is reduced by reported operating expenses that reduce
gross profit to net income
– Replacement cost of the inventory usually exceeds the reported inventory
cost, even if FIFO is used

Impact on Financial Statements

• Cash flow is higher when LIFO is used for tax reporting

• LIFO generally results in a lower profit LIFO profit reflects current costs of sales
• FIFO inventory is closer to replacement value of the asset
• LIFO reserve
– Measures the spread between LIFO and FIFO inventory value
– Discloses the approximate FIFO inventory value

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

• 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

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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

• 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

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Inventory Turnover in Days

This is the same formula for determining the days’ sales in inventory, except that it uses the
average inventory.

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The inventory turnover in days can be used to compute the inventory turnover per year, as follows:

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Operating Cycle
• The period between acquisition of goods and the final cash realization from sales

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Prepayments
– Unexpired costs for which payment has been made
– Consumed within an operating cycle or a year, whichever is longer
– Have minor influence on short-term debt-paying ability
– Valuation is taken as the cost that has been paid
– No liquidity computation is needed as prepayment will not result in a receipt
of cash

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Current Liabilities

Current liabilities are a company's short-term financial obligations that are

due within one year or within a normal operating cycle.

Current liabilities are typically settled using current assets, which are
assets that are used up within one year.

Examples:
Accounts payable, notes payable, accrued wages, accrued taxes, collections
received in advance, and current portions of long-term liabilities

Liquidity Ratios
A comparison of current assets with current liabilities indicates the short-term debt-paying
ability of the entity. Several comparisons can be made to determine this ability:

1. Working capital
2. Current ratio
3. Acid-test ratio
4. Cash ratio

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Working capital

Working Capital = Current Assets - Current Liabilities

• 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

Notes:

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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

Notes:

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Acid-Test Ratio (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

It may also be desirable to exclude some other items from current assets that may not represent
current cash flow, such as prepaid and miscellaneous items. Compute the more conservative acid-
test ratio as follows:

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It may also be desirable to exclude some other items from current assets that may not represent
current cash flow, such as prepaid and miscellaneous items. Compute the more conservative acid-
test ratio as follows:

Notes:

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Cash Ratio

• Extremely conservative
– Unrealistic for a firm to have sufficient cash and securities to cover
all its current liabilities
• Analysts should consider the cash ratio of companies that have naturally slow-moving
inventories and receivables and companies that are highly speculative. For example, a
land development company in Florida may sell lots paid for over a number of years on
the install- ment basis, or the success of a new company may be in doubt.

• The cash ratio indicates the immediate liquidity of the firm. A high cash ratio indicates that the firm
is not using its cash to its best advantage; cash should be put to work in the operations of the
company. Detailed knowledge of the firm is required, however, before drawing a definite
conclusion. Management may have plans for the cash, such as a building expansion program. A
cash ratio that is too low could indicate an immediate problem with paying bills.

Notes:

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