advanced short-term liquidity analysis chapter 9

ADVANCED ADVANCED SHORT-TERM SHORT-TERM LIQUIDITY LIQUIDITY ANALYSISANALYSIS

Chapter 9Chapter 9

CHAPTER 9 OBJECTIVESCHAPTER 9 OBJECTIVES

Compute and interpret an entity’s Compute and interpret an entity’s liquidity index.liquidity index.

Explain how inventory cost-flow Explain how inventory cost-flow assumptions, LIFO reserves, and assumptions, LIFO reserves, and LIFO liquidations affect inventory LIFO liquidations affect inventory analysis. analysis.

Indicate how cash sales and Indicate how cash sales and uncollectible accounts influence uncollectible accounts influence analysis of accounts receivable. analysis of accounts receivable.

CHAPTER 9 OBJECTIVES CHAPTER 9 OBJECTIVES (CONT.)(CONT.)

Articulate why converting expenses to Articulate why converting expenses to related cash-based amounts benefits related cash-based amounts benefits analysis of current liabilities.analysis of current liabilities.

Discuss the importance of financial Discuss the importance of financial flexibility in liquidity analysis.flexibility in liquidity analysis.

Describe why some technical adjustments Describe why some technical adjustments to liquidity measures are sometimes to liquidity measures are sometimes impossible to compute or unnecessary to impossible to compute or unnecessary to analysis.analysis.

Provide a detailed liquidity analysis of a Provide a detailed liquidity analysis of a company or industry.company or industry.

CURRENT ASSET CURRENT ASSET LIQUIDITYLIQUIDITY

The liquidity index quantifies overall The liquidity index quantifies overall asset current liquidityasset current liquidity Computed as total product days / current Computed as total product days / current

assetsassets A current asset’s total product days equals A current asset’s total product days equals

its account balance * the number of days it its account balance * the number of days it is removed from cashis removed from cash

Prepaid expenses are excluded from the Prepaid expenses are excluded from the calculationcalculation

Liquidity index interpretationLiquidity index interpretation Liquidity is inversely related to the indexLiquidity is inversely related to the index

INVENTORY ACTIVITY INVENTORY ACTIVITY MEASURESMEASURES

Inventory cost flow measuresInventory cost flow measures Managerial reporting assumption Managerial reporting assumption

about which inventory items are sold about which inventory items are sold firstfirst

The first-in, first-out (FIFO) method The first-in, first-out (FIFO) method assumes the first units available for assumes the first units available for sale are sold firstsale are sold first

The last-in, first-out (LIFO) method The last-in, first-out (LIFO) method assumes the last units available for assumes the last units available for sale are sold firstsale are sold first

INVENTORY ACTIVITY INVENTORY ACTIVITY MEASURES (CONT.)MEASURES (CONT.)

FIFO equals LISH or last-in, still-FIFO equals LISH or last-in, still-here; the last units available for here; the last units available for sale compose ending inventorysale compose ending inventory

LIFO equals FISH or first-in, still-LIFO equals FISH or first-in, still-here; the first units available for here; the first units available for sale compose ending inventorysale compose ending inventory


Financial statement implications (Exhibit 9-Financial statement implications (Exhibit 9-1)1) The FIFO inventory disclosure better The FIFO inventory disclosure better

approximates current inventory cost than does approximates current inventory cost than does the LIFO one the LIFO one

LIFO cost of goods sold better current period LIFO cost of goods sold better current period match costs with revenues than that of FIFOmatch costs with revenues than that of FIFO

FIFO reports higher income than LIFO does when FIFO reports higher income than LIFO does when prices are increasing prices are increasing

LIFO reports higher income than FIFO does when LIFO reports higher income than FIFO does when prices are decreasing prices are decreasing


Financial statement implications Financial statement implications (Exhibit 9-1)(Exhibit 9-1) Alternative inventory-related Alternative inventory-related

disclosures produced by FIFO and LIFO disclosures produced by FIFO and LIFO affect inventory activity measuresaffect inventory activity measures

LIFO reports faster inventory turnover LIFO reports faster inventory turnover than FIFO does when prices are risingthan FIFO does when prices are rising

LIFO reports fewer days in inventory LIFO reports fewer days in inventory than FIFO does when prices are risingthan FIFO does when prices are rising


LIFO reservesLIFO reserves The difference between LIFO and FIFO The difference between LIFO and FIFO

inventory and cost of goods sold when LIFO inventory and cost of goods sold when LIFO is used to report inventoryis used to report inventory

Analysts can convert LIFO disclosures to Analysts can convert LIFO disclosures to FIFO-based cost of sales and inventory with FIFO-based cost of sales and inventory with the aid of LIFO reserve disclosuresthe aid of LIFO reserve disclosures

Using the cost of goods sold section Using the cost of goods sold section facilities conversion from LIFO to FIFO facilities conversion from LIFO to FIFO disclosures (Exhibit 9-2)disclosures (Exhibit 9-2)


LIFO liquidationLIFO liquidation Occurs when inventory levels are Occurs when inventory levels are

reduced below their beginning balancereduced below their beginning balance Matches previous periods’ costs Matches previous periods’ costs

against current period’s revenuesagainst current period’s revenues Reports more income than is Reports more income than is

sustainable over timesustainable over time Notational disclosures address LIFO Notational disclosures address LIFO

liquidation’s impact on incomeliquidation’s impact on income


Manufacturing considerationsManufacturing considerations Inventory turnover measures the Inventory turnover measures the

number of times finished goods number of times finished goods inventory is soldinventory is sold

A manufacturing concern has three A manufacturing concern has three types of inventorytypes of inventory

Raw materialsRaw materials Work in process Work in process Finished goodsFinished goods


Manufacturing considerations Manufacturing considerations (cont.)(cont.) Using all three inventory amounts Using all three inventory amounts

understates the turnover ratio (by understates the turnover ratio (by overstating its denominator)overstating its denominator)

No adjustment is needed so long as No adjustment is needed so long as the proportion of raw materials, work the proportion of raw materials, work in process and finished goods are in process and finished goods are relatively constant over time and relatively constant over time and compatible with benchmark firmscompatible with benchmark firms

ACCOUNTS RECEIVABLE ACCOUNTS RECEIVABLE ACTIVITY MEASURESACTIVITY MEASURES

Revenues are realized when goods Revenues are realized when goods are sold or services providedare sold or services provided

Company receives either cash or a Company receives either cash or a promise of cash (credit sales promise of cash (credit sales creating accounts receivable) creating accounts receivable) when revenues are realizedwhen revenues are realized

The potential exists that credit The potential exists that credit sales will not be collected in cashsales will not be collected in cash

ACCOUNTS RECEIVABLE ACCOUNTS RECEIVABLE ACTIVITY MEASURES ACTIVITY MEASURES (CONT.)(CONT.)

Companies do not disclose cash and Companies do not disclose cash and credit salescredit sales

Only credit sales should be used in Only credit sales should be used in computing accounts receivable turnovercomputing accounts receivable turnover

Including cash sales in the numerator Including cash sales in the numerator overstates the accounts receivable overstates the accounts receivable turnover ratioturnover ratio

Lack of disclosure precludes adjusting Lack of disclosure precludes adjusting the accounts receivable turnover ratiothe accounts receivable turnover ratio


Bad DebtsBad Debts The inability to collect certain The inability to collect certain

outstanding receivables is a cost of outstanding receivables is a cost of extending creditextending credit

Bad debt expense (part of operating Bad debt expense (part of operating expenses) matches that business cost expenses) matches that business cost against the revenues realized in a against the revenues realized in a reporting periodreporting period


Bad Debts (cont.)Bad Debts (cont.) The allowance for uncollectible accounts The allowance for uncollectible accounts

reduces accounts receivable to its net reduces accounts receivable to its net amountamount

Net accounts receivable are reported on the Net accounts receivable are reported on the balance sheetbalance sheet

Supplemental disclosures present an Supplemental disclosures present an entity’s annual bad debt expense and write-entity’s annual bad debt expense and write-offs of uncollectible accounts (Exhibit 9-5)offs of uncollectible accounts (Exhibit 9-5)

ACCOUNTS PAYABLE ACCOUNTS PAYABLE ACTIVITY MEASURESACTIVITY MEASURES

Accrued liability activity measures Accrued liability activity measures Similar approach to computing Similar approach to computing

accounts payable turnoveraccounts payable turnover Accrued liability turnover equals Accrued liability turnover equals

operating expenses / average accrued operating expenses / average accrued liabilitiesliabilities

Number of days in accrued liabilities Number of days in accrued liabilities equals 365 days / accrued liability equals 365 days / accrued liability turnoverturnover

ACCOUNTS PAYABLE ACCOUNTS PAYABLE ACTIVITY MEASURES ACTIVITY MEASURES (CONT.)(CONT.)

Conceptual considerations for current Conceptual considerations for current liability measuresliability measures Vendor obligations are paid in cash Vendor obligations are paid in cash The accounts payable turnover ratio should The accounts payable turnover ratio should

use purchases (rather than cost of goods use purchases (rather than cost of goods sold) in its numeratorsold) in its numerator

Certain operating expenses do not require Certain operating expenses do not require cash payment (e.g., depreciation)cash payment (e.g., depreciation)

The accrued liability turnover ratio should The accrued liability turnover ratio should subtract non-cash obligations from the subtract non-cash obligations from the denominator of the ratiodenominator of the ratio

FINANCIAL FLEXIBILITYFINANCIAL FLEXIBILITY

Enables an organization to Enables an organization to Take advantage of unexpected Take advantage of unexpected

opportunitiesopportunities Meet unforeseen obligationsMeet unforeseen obligations

FINANCIAL FLEXIBILITY FINANCIAL FLEXIBILITY (CONT.)(CONT.)

Analysts should assess financial Analysts should assess financial flexibility with flexibility with what ifwhat if scenarios scenarios List the possible unexpected List the possible unexpected

opportunities and unforeseen opportunities and unforeseen circumstancescircumstances

Assign probabilities to themAssign probabilities to them Investigate the affect of the more Investigate the affect of the more

probable occurrences on financial probable occurrences on financial flexibilityflexibility


Sources of financial flexibilitySources of financial flexibility Lines of creditLines of credit

Prearranged loan with a maximum Prearranged loan with a maximum loan amountloan amount

Available for most firmsAvailable for most firms Callable at any timeCallable at any time


Sources of financial flexibility Sources of financial flexibility (cont.)(cont.)

Commercial paper (short-term Commercial paper (short-term promissory notes)promissory notes) Unsecured loansUnsecured loans Only available to most creditworthy Only available to most creditworthy

firmsfirms Costly instruments to issueCostly instruments to issue

THE PC INDUSTRYTHE PC INDUSTRY

The liquidity index demonstrates The liquidity index demonstrates the industry’s increasing liquidity the industry’s increasing liquidity (Exhibit 9-7)(Exhibit 9-7)

Lower index in the later years of Lower index in the later years of the analysisthe analysis

Corporate liquidity increased Corporate liquidity increased despite a decline in their current despite a decline in their current ratiosratios

Exhibit 9-7PC Industry

Liquidity Indices1994-1998

0

10

20

30

40

50

60

1994 1995 1996 1997 1998

Liqu

idity

Inde

x

Apple Computer, Inc. Compaq Computer Corp.

Dell Computer Corp. Gateway 2000, Inc.

THE PC INDUSTRY (CONT.)THE PC INDUSTRY (CONT.)

Inventory analysisInventory analysis Decline in inventory component costs Decline in inventory component costs

and the amount of inventory heldand the amount of inventory held All four companies cost inventory on a All four companies cost inventory on a

FIFO basisFIFO basis LIFO reserves are not a reporting issues LIFO reserves are not a reporting issues LIFO liquidation is not a reporting issueLIFO liquidation is not a reporting issue

1998

Other Assets98.2%

Inventory1.8%

Other Assets Inventory

1993

Inventory29.1%

Other Assets70.9%

Other Assets Inventory


The importance of inventory The importance of inventory analysis diminished over timeanalysis diminished over time

Industry maturation required more Industry maturation required more efficient operating cyclesefficient operating cycles

All firms greatly reduced their All firms greatly reduced their inventoriesinventories


Receivable analysisReceivable analysis Changes in receivables differed among Changes in receivables differed among

companies during the period analyzed companies during the period analyzed (Exhibit 9-10)(Exhibit 9-10) Apple’s receivables declined (as did their Apple’s receivables declined (as did their

revenues)revenues) Compaq’s receivables increased faster than Compaq’s receivables increased faster than

their revenues didtheir revenues did Dell’s and Gateway’s receivables increased Dell’s and Gateway’s receivables increased

slower than their revenues did slower than their revenues did


None of the companies disclosed their None of the companies disclosed their cash and credit revenues cash and credit revenues

Apple appears to adequately provide for Apple appears to adequately provide for bad debts (Exhibit 9-11)bad debts (Exhibit 9-11) The company had a large beginning balance The company had a large beginning balance

in its allowance accountin its allowance account Annual bad debt expenses approximated Annual bad debt expenses approximated

receivable write-offsreceivable write-offs The company maintained its large The company maintained its large

allowance account balance at the end of allowance account balance at the end of 19981998

APPLE’S BAD DEBTSAPPLE’S BAD DEBTS

Year Beginning Balance Bad Debt Expense Reductions Ending Balance12/31/03 $4,000 $7,000 $6,000 $5,000 12/31/02 $2,000 $5,000 $3,000 $4,000


Current liability analysisCurrent liability analysis Became less of a concern in the Became less of a concern in the

industry over time industry over time Increased liquidityIncreased liquidity Reduced vendor obligations (due to Reduced vendor obligations (due to

inventory declines)inventory declines) Technical adjustments not needed Technical adjustments not needed

because of strong liquidity positionbecause of strong liquidity position


Financial flexibilityFinancial flexibility The industry increased financial The industry increased financial

flexibility from 1993 to 1998flexibility from 1993 to 1998 Companies reported rapid growth in Companies reported rapid growth in

cash and marketable securitiescash and marketable securities Apple’s deteriorating financial Apple’s deteriorating financial

position increased its short-term position increased its short-term borrowing costsborrowing costs

advanced short-term liquidity analysis chapter 9

Documents

inventory analysis

current inventory cost

lifo disclosures

lifo cost of goods

lifo method

fifo inventory disclosure

lifo liquidationoccurs

inventory levels