Transcript Advanced Short-Term Liquidity Analysis

ADVANCED SHORTTERM LIQUIDITY
ANALYSIS
Chapter 9
CHAPTER 9 OBJECTIVES
Compute and interpret an entity’s
liquidity index.
 Explain how inventory cost-flow
assumptions, LIFO reserves, and LIFO
liquidations affect inventory analysis.
 Indicate how cash sales and
uncollectible accounts influence analysis
of accounts receivable.

CHAPTER 9 OBJECTIVES
(CONT.)
Articulate why converting expenses to related
cash-based amounts benefits analysis of
current liabilities.
 Discuss the importance of financial flexibility
in liquidity analysis.
 Describe why some technical adjustments to
liquidity measures are sometimes impossible
to compute or unnecessary to analysis.
 Provide a detailed liquidity analysis of a
company or industry.
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CURRENT ASSET LIQUIDITY
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The liquidity index quantifies overall asset
current liquidity
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Computed as total product days / current assets
A current asset’s total product days equals its
account balance * the number of days it is
removed from cash
Prepaid expenses are excluded from the
calculation
Liquidity index interpretation
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Liquidity is inversely related to the index
INVENTORY ACTIVITY
MEASURES

Inventory cost flow measures
Managerial reporting assumption about
which inventory items are sold first
 The first-in, first-out (FIFO) method
assumes the first units available for sale
are sold first
 The last-in, first-out (LIFO) method
assumes the last units available for sale are
sold first
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INVENTORY ACTIVITY
MEASURES (CONT.)
FIFO equals LISH or last-in, still-here;
the last units available for sale compose
ending inventory
 LIFO equals FISH or first-in, still-here;
the first units available for sale compose
ending inventory
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INVENTORY ACTIVITY
MEASURES (CONT.)
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Financial statement implications (Exhibit 9-1)
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The FIFO inventory disclosure better approximates
current inventory cost than does the LIFO one
LIFO cost of goods sold better current period
match costs with revenues than that of FIFO
FIFO reports higher income than LIFO does when
prices are increasing
LIFO reports higher income than FIFO does when
prices are decreasing
INVENTORY ACTIVITY
MEASURES (CONT.)
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Financial statement implications (Exhibit
9-1)
Alternative inventory-related disclosures
produced by FIFO and LIFO affect
inventory activity measures
 LIFO reports faster inventory turnover than
FIFO does when prices are rising
 LIFO reports fewer days in inventory than
FIFO does when prices are rising
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INVENTORY ACTIVITY
MEASURES (CONT.)
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LIFO reserves
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The difference between LIFO and FIFO inventory
and cost of goods sold when LIFO is used to
report inventory
Analysts can convert LIFO disclosures to FIFObased cost of sales and inventory with the aid of
LIFO reserve disclosures
Using the cost of goods sold section facilities
conversion from LIFO to FIFO disclosures (Exhibit
9-2)
INVENTORY ACTIVITY
MEASURES (CONT.)
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LIFO liquidation
Occurs when inventory levels are reduced
below their beginning balance
 Matches previous periods’ costs against
current period’s revenues
 Reports more income than is sustainable
over time
 Notational disclosures address LIFO
liquidation’s impact on income
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INVENTORY ACTIVITY
MEASURES (CONT.)
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Manufacturing considerations
Inventory turnover measures the number
of times finished goods inventory is sold
 A manufacturing concern has three types
of inventory
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Raw materials
 Work in process
 Finished goods
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INVENTORY ACTIVITY
MEASURES (CONT.)
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Manufacturing considerations (cont.)
Using all three inventory amounts
understates the turnover ratio (by
overstating its denominator)
 No adjustment is needed so long as the
proportion of raw materials, work in
process and finished goods are relatively
constant over time and compatible with
benchmark firms
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ACCOUNTS RECEIVABLE
ACTIVITY MEASURES
Revenues are realized when goods are
sold or services provided
 Company receives either cash or a
promise of cash (credit sales creating
accounts receivable) when revenues are
realized
 The potential exists that credit sales will
not be collected in cash
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ACCOUNTS RECEIVABLE
ACTIVITY MEASURES (CONT.)
Companies do not disclose cash and credit
sales
 Only credit sales should be used in computing
accounts receivable turnover
 Including cash sales in the numerator
overstates the accounts receivable turnover
ratio
 Lack of disclosure precludes adjusting the
accounts receivable turnover ratio
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ACCOUNTS RECEIVABLE
ACTIVITY MEASURES (CONT.)
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Bad Debts
The inability to collect certain outstanding
receivables is a cost of extending credit
 Bad debt expense (part of operating
expenses) matches that business cost
against the revenues realized in a reporting
period
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ACCOUNTS RECEIVABLE
ACTIVITY MEASURES (CONT.)
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Bad Debts (cont.)
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The allowance for uncollectible accounts reduces
accounts receivable to its net amount
Net accounts receivable are reported on the
balance sheet
Supplemental disclosures present an entity’s
annual bad debt expense and write-offs of
uncollectible accounts (Exhibit 9-5)
ACCOUNTS PAYABLE
ACTIVITY MEASURES
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Accrued liability activity measures
Similar approach to computing accounts
payable turnover
 Accrued liability turnover equals operating
expenses / average accrued liabilities
 Number of days in accrued liabilities equals
365 days / accrued liability turnover
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ACCOUNTS PAYABLE
ACTIVITY MEASURES (CONT.)
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Conceptual considerations for current liability
measures
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Vendor obligations are paid in cash
The accounts payable turnover ratio should use
purchases (rather than cost of goods sold) in its
numerator
Certain operating expenses do not require cash
payment (e.g., depreciation)
The accrued liability turnover ratio should subtract
non-cash obligations from the denominator of the
ratio
FINANCIAL FLEXIBILITY
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Enables an organization to
Take advantage of unexpected
opportunities
 Meet unforeseen obligations
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FINANCIAL FLEXIBILITY
(CONT.)
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Analysts should assess financial
flexibility with what if scenarios
List the possible unexpected opportunities
and unforeseen circumstances
 Assign probabilities to them
 Investigate the affect of the more probable
occurrences on financial flexibility
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FINANCIAL FLEXIBILITY
(CONT.)
Sources of financial flexibility
 Lines of credit
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Prearranged loan with a maximum loan
amount
 Available for most firms
 Callable at any time
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FINANCIAL FLEXIBILITY
(CONT.)
Sources of financial flexibility (cont.)
 Commercial paper (short-term
promissory notes)
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Unsecured loans
 Only available to most creditworthy firms
 Costly instruments to issue
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THE PC INDUSTRY
The liquidity index demonstrates the
industry’s increasing liquidity (Exhibit 97)
 Lower index in the later years of the
analysis
 Corporate liquidity increased despite a
decline in their current ratios
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Exhibit 9-7
PC Industry
Liquidity Indices
1994-1998
60
Liquidity Index
50
40
30
20
10
0
1994
1995
1996
1997
1998
Apple Computer, Inc.
Compaq Computer Corp.
Dell Computer Corp.
Gateway 2000, Inc.
THE PC INDUSTRY (CONT.)
Inventory analysis
 Decline in inventory component costs
and the amount of inventory held
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All four companies cost inventory on a
FIFO basis
 LIFO reserves are not a reporting issues
 LIFO liquidation is not a reporting issue
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1993
1998
Inventory
1.8%
Inventory
29.1%
Other
Assets
98.2%
Other
Assets
70.9%
Other Assets Inventory
Other Assets Inventory
THE PC INDUSTRY (CONT.)
The importance of inventory analysis
diminished over time
 Industry maturation required more
efficient operating cycles
 All firms greatly reduced their
inventories
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THE PC INDUSTRY (CONT.)
Receivable analysis
 Changes in receivables differed among
companies during the period analyzed
(Exhibit 9-10)
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Apple’s receivables declined (as did their
revenues)
Compaq’s receivables increased faster than their
revenues did
Dell’s and Gateway’s receivables increased slower
than their revenues did
THE PC INDUSTRY (CONT.)
None of the companies disclosed their cash
and credit revenues
 Apple appears to adequately provide for bad
debts (Exhibit 9-11)
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The company had a large beginning balance in its
allowance account
Annual bad debt expenses approximated
receivable write-offs
The company maintained its large allowance
account balance at the end of 1998
APPLE’S BAD DEBTS
Year Beginning Balance Bad Debt Expense Reductions Ending Balance
12/31/03
$4,000
$7,000 $6,000
$5,000
12/31/02
$2,000
$5,000 $3,000
$4,000
THE PC INDUSTRY (CONT.)
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Current liability analysis
Became less of a concern in the industry
over time
 Increased liquidity
 Reduced vendor obligations (due to
inventory declines)
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Technical adjustments not needed
because of strong liquidity position
THE PC INDUSTRY (CONT.)
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Financial flexibility
The industry increased financial flexibility
from 1993 to 1998
 Companies reported rapid growth in cash
and marketable securities
 Apple’s deteriorating financial position
increased its short-term borrowing costs
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