ADVANCED SHORT-TERM LIQUIDITY ANALYSIS Chapter 9

CHAPTER 9 OBJECTIVES Compute and interpret an entity’s liquidity index. Compute and interpret an entity’s liquidity index. Explain how inventory cost-flow assumptions, LIFO reserves, and LIFO liquidations affect inventory analysis. 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. 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. Articulate why converting expenses to related cash-based amounts benefits analysis of current liabilities. Discuss the importance of financial flexibility in liquidity analysis. 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. 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. Provide a detailed liquidity analysis of a company or industry.

CURRENT ASSET LIQUIDITY The liquidity index quantifies overall asset current liquidity The liquidity index quantifies overall asset current liquidity Computed as total product days / current assets 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 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 Prepaid expenses are excluded from the calculation Liquidity index interpretation Liquidity index interpretation Liquidity is inversely related to the index Liquidity is inversely related to the index

INVENTORY ACTIVITY MEASURES Inventory cost flow measures Inventory cost flow measures Managerial reporting assumption about which inventory items are sold first 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 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 The last-in, first-out (LIFO) method assumes the last units available for sale are sold first

INVENTORY ACTIVITY MEASURES (CONT.) FIFO equals LISH or last-in, still-here; the last units available for sale compose ending inventory 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 LIFO equals FISH or first-in, still-here; the first units available for sale compose ending inventory

INVENTORY ACTIVITY MEASURES (CONT.) Financial statement implications (Exhibit 9-1) Financial statement implications (Exhibit 9-1) The FIFO inventory disclosure better approximates current inventory cost than does the LIFO one 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 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 FIFO reports higher income than LIFO does when prices are increasing LIFO reports higher income than FIFO does when prices are decreasing LIFO reports higher income than FIFO does when prices are decreasing

INVENTORY ACTIVITY MEASURES (CONT.) Financial statement implications (Exhibit 9-1) Financial statement implications (Exhibit 9-1) Alternative inventory-related disclosures produced by FIFO and LIFO affect inventory activity measures 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 faster inventory turnover than FIFO does when prices are rising LIFO reports fewer days in inventory than FIFO does when prices are rising LIFO reports fewer days in inventory than FIFO does when prices are rising

INVENTORY ACTIVITY MEASURES (CONT.) LIFO reserves LIFO reserves The difference between LIFO and FIFO inventory and cost of goods sold when LIFO is used to report inventory 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 FIFO- based cost of sales and inventory with the aid of LIFO reserve disclosures Analysts can convert LIFO disclosures to FIFO- based 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) Using the cost of goods sold section facilities conversion from LIFO to FIFO disclosures (Exhibit 9-2)

INVENTORY ACTIVITY MEASURES (CONT.) LIFO liquidation LIFO liquidation Occurs when inventory levels are reduced below their beginning balance Occurs when inventory levels are reduced below their beginning balance Matches previous periods’ costs against current period’s revenues Matches previous periods’ costs against current period’s revenues Reports more income than is sustainable over time Reports more income than is sustainable over time Notational disclosures address LIFO liquidation’s impact on income Notational disclosures address LIFO liquidation’s impact on income

INVENTORY ACTIVITY MEASURES (CONT.) Manufacturing considerations Manufacturing considerations Inventory turnover measures the number of times finished goods inventory is sold Inventory turnover measures the number of times finished goods inventory is sold A manufacturing concern has three types of inventory A manufacturing concern has three types of inventory Raw materials Raw materials Work in process Work in process Finished goods Finished goods

INVENTORY ACTIVITY MEASURES (CONT.) Manufacturing considerations (cont.) Manufacturing considerations (cont.) Using all three inventory amounts understates the turnover ratio (by overstating its denominator) 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 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

ACCOUNTS RECEIVABLE ACTIVITY MEASURES Revenues are realized when goods are sold or services provided 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 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 The potential exists that credit sales will not be collected in cash

ACCOUNTS RECEIVABLE ACTIVITY MEASURES (CONT.) Companies do not disclose cash and credit sales Companies do not disclose cash and credit sales Only credit sales should be used in computing accounts receivable turnover Only credit sales should be used in computing accounts receivable turnover Including cash sales in the numerator overstates the accounts receivable turnover ratio Including cash sales in the numerator overstates the accounts receivable turnover ratio Lack of disclosure precludes adjusting the accounts receivable turnover ratio Lack of disclosure precludes adjusting the accounts receivable turnover ratio

ACCOUNTS RECEIVABLE ACTIVITY MEASURES (CONT.) Bad Debts Bad Debts The inability to collect certain outstanding receivables is a cost of extending credit 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 Bad debt expense (part of operating expenses) matches that business cost against the revenues realized in a reporting period

ACCOUNTS RECEIVABLE ACTIVITY MEASURES (CONT.) Bad Debts (cont.) Bad Debts (cont.) The allowance for uncollectible accounts reduces accounts receivable to its net amount The allowance for uncollectible accounts reduces accounts receivable to its net amount Net accounts receivable are reported on the balance sheet 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) Supplemental disclosures present an entity’s annual bad debt expense and write-offs of uncollectible accounts (Exhibit 9-5)

ACCOUNTS PAYABLE ACTIVITY MEASURES Accrued liability activity measures Accrued liability activity measures Similar approach to computing accounts payable turnover Similar approach to computing accounts payable turnover Accrued liability turnover equals operating expenses / average accrued liabilities Accrued liability turnover equals operating expenses / average accrued liabilities Number of days in accrued liabilities equals 365 days / accrued liability turnover Number of days in accrued liabilities equals 365 days / accrued liability turnover

ACCOUNTS PAYABLE ACTIVITY MEASURES (CONT.) Conceptual considerations for current liability measures Conceptual considerations for current liability measures Vendor obligations are paid in cash Vendor obligations are paid in cash The accounts payable turnover ratio should use purchases (rather than cost of goods sold) in its numerator 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) 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 The accrued liability turnover ratio should subtract non-cash obligations from the denominator of the ratio

FINANCIAL FLEXIBILITY Enables an organization to Enables an organization to Take advantage of unexpected opportunities Take advantage of unexpected opportunities Meet unforeseen obligations Meet unforeseen obligations

FINANCIAL FLEXIBILITY (CONT.) Analysts should assess financial flexibility with what if scenarios Analysts should assess financial flexibility with what if scenarios List the possible unexpected opportunities and unforeseen circumstances List the possible unexpected opportunities and unforeseen circumstances Assign probabilities to them Assign probabilities to them Investigate the affect of the more probable occurrences on financial flexibility Investigate the affect of the more probable occurrences on financial flexibility

FINANCIAL FLEXIBILITY (CONT.) Sources of financial flexibility Sources of financial flexibility Lines of credit Lines of credit Prearranged loan with a maximum loan amount Prearranged loan with a maximum loan amount Available for most firms Available for most firms Callable at any time Callable at any time

FINANCIAL FLEXIBILITY (CONT.) Sources of financial flexibility (cont.) Sources of financial flexibility (cont.) Commercial paper (short-term promissory notes) Commercial paper (short-term promissory notes) Unsecured loans Unsecured loans Only available to most creditworthy firms Only available to most creditworthy firms Costly instruments to issue Costly instruments to issue

THE PC INDUSTRY The liquidity index demonstrates the industry’s increasing liquidity (Exhibit 9- 7) The liquidity index demonstrates the industry’s increasing liquidity (Exhibit 9- 7) Lower index in the later years of the analysis Lower index in the later years of the analysis Corporate liquidity increased despite a decline in their current ratios Corporate liquidity increased despite a decline in their current ratios

THE PC INDUSTRY (CONT.) Inventory analysis Inventory analysis Decline in inventory component costs and the amount of inventory held Decline in inventory component costs and the amount of inventory held All four companies cost inventory on a FIFO basis All four companies cost inventory on a FIFO basis LIFO reserves are not a reporting issues LIFO reserves are not a reporting issues LIFO liquidation is not a reporting issue LIFO liquidation is not a reporting issue

THE PC INDUSTRY (CONT.) The importance of inventory analysis diminished over time The importance of inventory analysis diminished over time Industry maturation required more efficient operating cycles Industry maturation required more efficient operating cycles All firms greatly reduced their inventories All firms greatly reduced their inventories

THE PC INDUSTRY (CONT.) Receivable analysis Receivable analysis Changes in receivables differed among companies during the period analyzed (Exhibit 9-10) Changes in receivables differed among companies during the period analyzed (Exhibit 9-10) Apple’s receivables declined (as did their revenues) Apple’s receivables declined (as did their revenues) Compaq’s receivables increased faster than their revenues did Compaq’s receivables increased faster than their revenues did Dell’s and Gateway’s receivables increased slower 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 None of the companies disclosed their cash and credit revenues Apple appears to adequately provide for bad debts (Exhibit 9-11) Apple appears to adequately provide for bad debts (Exhibit 9-11) The company had a large beginning balance in its allowance account The company had a large beginning balance in its allowance account Annual bad debt expenses approximated receivable write-offs Annual bad debt expenses approximated receivable write-offs The company maintained its large allowance account balance at the end of 1998 The company maintained its large allowance account balance at the end of 1998

APPLE’S BAD DEBTS

THE PC INDUSTRY (CONT.) Current liability analysis Current liability analysis Became less of a concern in the industry over time Became less of a concern in the industry over time Increased liquidity Increased liquidity Reduced vendor obligations (due to inventory declines) Reduced vendor obligations (due to inventory declines) Technical adjustments not needed because of strong liquidity position Technical adjustments not needed because of strong liquidity position

THE PC INDUSTRY (CONT.) Financial flexibility Financial flexibility The industry increased financial flexibility from 1993 to 1998 The industry increased financial flexibility from 1993 to 1998 Companies reported rapid growth in cash and marketable securities Companies reported rapid growth in cash and marketable securities Apple’s deteriorating financial position increased its short-term borrowing costs Apple’s deteriorating financial position increased its short-term borrowing costs