FINC 3338 FSA Questions Ch. 6

List three situations in which the liquidity position of the firm may be better than that indicated by the liquidity ratios.

1. Unused bank credit lines 2. Long-term assets that have the potential to be converted to cash quickly. 3. Capability to issue debt or stock.

Several comparisons can be made to determine the short-term debt-paying ability of an entity. Some of these are: a. Working capital b. Current ratio c. Acid-test ratio d. Cash ratio 1. Define each of these terms. 2. If the book figures are based on cost, will the results of the preceding computations tend to be understated or overstated? Explain. 3. What figures should be used in order to avoid the problem referred to in (2)?

1. a. The excess of current assets over current liabilities b.The ratio of total current assets to total current liabilities c. The ratio of total current assets less inventory to total current liabilities d. The ratio of total current assets less inventory and receivables to total current liabilities. 2. a. Working capital based on cost figures will tend to be understated because inventory will be stated at amounts that do not represent current value. b. The current ratio will tend to be understated because inventory will be stated at amounts that do not represent current value c. The acid-test ratio will tend to be accurate d. The cash ratio will tend to be accurate. 3. To avoid the understatements in working capital and the current ratio, use the replacement (current) cost of inventory when it is disclosed.

Would a company that uses a natural business year tend to overstate or understate the liquidity of its receivables? Explain.

A company that uses a natural business year would tend to overstate the liquidity of its receivables. The 2 computations that are made to indicate the liquidity of receivables are the days' sales in receivables and the accounts receivable turnover. Because the receivables would be at or near their low point at the end of a natural business year, the days' sales in receivables would be low at the end of the year in comparison with usual days' sales in receivables during the year. The accounts receivable turnover would be high, based on the natural business year in relation to the turnover and the receivables figures during the year.

Before computing the current ratio, the accounts receivable turnover and the inventory turnover should be computed. Why?

Accounts receivable and inventory are often major segments of current assets. Therefore, they can have a material influence on the current ratio. Accounts receivable turnover and the merchandise inventory turnover are ratios that will aid the analyst in forming an opinion as to the quality of receivables and inventory. Poor quality in receivables and/or inventory will increase the current ratio, which indicates better liquidity than is the case.

Would a firm with a relatively long operating cycle tend to charge a higher markup on its inventory cost than a firm with a short operating cycle? Discuss.

Because funds to operate the business are costly to the firm, a firm with a longer operating cycle usually charges a high mark-up on its inventory cost when selling than does a firm with a short operating cycle. This enables the firm to recover the cost for the funds that are used to operate the business. A food store usually has a very low mark-up, while a car manufacturer would have a higher mark-up. Within the same industry, it is difficult to have a different mark-up from firm to firm, unless different services are provided or a different quality is supplied, due to competitive forces in price.

Why does LIFO result in a very unrealistic ending inventory figure in a period of rising prices?

Because the higher costs are reflected in the cost of sales (last in, first out), leaving old costs (lower) in inventory.

List the major categories of items usually found in current assets

Cash Marketable Securities Accounts Receivables Inventories Prepayments

What is the reason for separating current assets from the rest of the assets found on the balance sheet?

Current assets are assets that are in the form of cash or that will be realized in cash or that conserve the use of cash within an operating cycle of a business, or one year, whichever is the longer period of time.

Define current assets.

Current assets are assets that are in the form of cash or that will be realized in cash or that conserve the use of cash within the operating cycle of a business, or one year, whichever is the longer period of time.

Define current liabilities.

Current liabilities are obligations whose liquidation is reasonably expected to require the use of existing current assets or the creation of other current liabilities within a year or an operating cycle, whichever is longer.

List the two computations that are used to determine the liquidity of inventory.

Days' Sales in Inventory Inventory Turnover

List the two computations that are used to determine the liquidity of receivables.

Days' Sales in Receivables Accounts Receivable Turnover

Discuss some benefits that may accrue to a firm from reducing its operating cycle. Suggest some ways that may be used to reduce a company's operating cycle.

If a firm can reduce its operating cycle, it can benefit from having more funds available for operating or it could reduce the funds that it uses in operations. Since funds cost the firm money, it can increase profits by operating at a more efficient operating cycle. An improved operating cycle will enable the firm to operate with less plant and equipment and still maintain the present level of sales, thereby increasing profits. Or, the firm could expand the level of sales with the improved operating cycle without expanding plant and equipment. This expansion in sales could also mean greater profits. Opportunities to improve the operating cycle will be found in the management of the inventory and the accounts receivable.

The cost of inventory at the close of the calendar year of the first year of operation is $40,000, using LIFO in- ventory, resulting in a profit before tax of $100,000. If the FIFO inventory would have been $50,000, what would the reported profit before tax have been? If the average cost method would have resulted in an inventory of $45,000, what would the reported profit before tax have been? Should the inventory costing method be disclosed? Why?

FIFO inventory - reported profit Reported profit under LIFO: $100,000 Increase in ending inventory $10,000 Reported profit under FIFO: $110,000 Reported profit under LIFO: $100,000 Increase in ending inventory: $5,000 Reported profit under average cost: $105,000 Yes, the inventory costing method should be disclosed. The disclosure is necessary to have an understanding of how the amount was computed.

Which inventory costing method results in the highest balance sheet amount for inventory? (Assume inflationary conditions.)

FIFO represents the highest inventory balance under inflationary conditions.

It is proposed at a stockholders' meeting that the firm slow its rate of payments on accounts payable in order to make more funds available for operations. It is con- tended that this procedure will enable the firm to expand inventory, which will in turn enable the firm to generate more sales. Comment on this proposal.

In the very short run, the procedure of making more funds available by slowing the rate of payments on accounts payable would work and the firm would have more funds to purchase inventory, which would in turn enable the firm to generate more sales. This procedure would not work very long because creditors would demand payment and they may refuse to sell to our firm or demand cash upon delivery. In either case, the end result would be the opposite of what was intended.

Describe the difference in inventories between a firm that is a retail company and a firm that is a manufacturing concern.

Inventories of a retail company are usually classified in one inventory account called "merchandise inventory". Inventories of a manufacturing concern are normally classified in 3 inventory accounts. These inventory accounts distinguish between getting ready to produce (raw materials inventory), inventory in production (work in process inventory), and inventory completed (finished goods inventory).

A relatively low sales to working capital ratio is a tentative indication of an efficient use of working capital. Comment. A relatively high sales to working capital ratio is a tentative indication that the firm is under capitalized. Comment.

No, a low sales-to-working capital ratio is an indication of an unprofitable use of working capital. It indicates that low amounts of sales are being generated for each dollar of working capital. Yes, a high ratio is a tentative indication that the firm is under capitalized. This firm will likely have a high inventory turnover and a low current ratio.

Is the profitability of the entity considered to be of major importance in determining the short-term debt- paying ability? Discuss.

Profitability is often not of major importance in determining the short-term debt-paying ability of a firm. One of the reasons for this is that many revenue items and many expense items do not directly affect cash flow during the same period.

Before computing the acid-test ratio, compute the accounts receivable turnover. Comment.

Receivables can have a material influence on the acid-test ratio. Accounts receivable turnover will give some indication as to the quality of receivables. Poor quality in receivables will increase the acid-test ratio, which will result in the acid-test ratio appearing to be more favorable than it actually is.

T. Melcher Company uses the calendar year. Sales are at a peak during the holiday season, and T. Melcher Com- pany extends 30-day credit terms to customers. Comment on the expected liquidity of its receivables, based on the days' sales in receivables and the accounts receivable turnover.

Since the receivables will be at their peak at the end of the year, the days' sales in receivables will be high and the accounts receivable turnover will be low; thus, the liquidity will be understated when a firm closes its year at or near the peak of its business.

Discuss why some firms have longer natural operating cycles than other firms.

Some industries naturally need a longer operating cycle than others because of the nature of the industry. For example, we could not expect the car manufacturer to have an operating cycle that compares with that of a food store because it takes much longer to manufacture cars and collect the receivables from the sales than it does for the food store to buy its inventory and sell it for cash. Thus, comparing the operating cycles of a car manufacturer and a food store would not be a fair comparison.

Define the operating cycle.

The operating cycle is the period of time elapsing between the acquisition of goods and the final cash realization resulting from sales and subsequent collections.

In determining the short-term liquidity of a firm, the current ratio is usually considered to be a better guide than the acid-test ratio, and the acid-test ratio is considered to be a better guide than the cash ratio. Discuss when the acid-test ratio would be preferred over the current ratio and when the cash ratio would be preferred over the acid-test ratio.

The acid-test ratio is considered to be a better guide to short-term liquidity than the current ratio when there are problems with the short-run liquidity of inventory. Some problems with inventory could be in determining a reasonable dollar amount in relation the quantity on hand (LIFO inventory), the inventory has been pledged, or the inventory is held for a long period of time. The cash ratio would be preferred over the acid-test ratio when there is a problem with the liquidity of receivables. An example would be an entity that has a long collection period for receivables.

Rachit Company has cash that has been frozen in a bank in Cuba. Should this cash be classified as a current asset? Discuss.

The cash frozen in a bank in Cuba should be not classified as a current assets because it is not readily available to be used in operations.

Indicate the objective of the sales to working capital ratio.

The sales to working capital ratio gives an indication of whether capital is used unprofitably or is possibly overworked.

Both current assets and current liabilities are used in the computation of working capital and the current ratio, yet the current ratio is considered to be more indicative of the short-term debt-paying ability. Explain.

The current ratio is considered to be more indicative of the short-term debt paying ability than the working capital because the current ratio takes into account the relative relation between the size of the current assets and the size of the current liabilities. Working capital only determines the absolute difference between the current assets and the current liabilities.

Discuss how to use working capital in analysis.

The current working capital amount should be compared with past working capital amounts to determine if working capital is reasonable. Caution must be exercised because the relative size of the firm may be expanding or contracting. Comparing working capital of one firm with working capital of another firm will usually be meaningless because of the different sizes of the firms.

One of the computations used to determine the liquidity of inventory determines the inventory turnover. In this computation, usually the average inventory is deter- mined by using the beginning-of-the-year and the end-of-the- year inventory figures, but this computation can be misleading if the company has seasonal fluctuations or uses a natural business year. Suggest how to eliminate these distortions.

The distortions from seasonal fluctuations or the use of a natural business year can be eliminated by using monthly inventory figures when computing the average inventory that will then be divided into cost of goods sold.

If a company has substantial cash sales and credit sales, is there any meaning to the receivable liquidity computations that are based on gross sales?

The liquidity of the receivables will be overstated if the sales figure includes both cash sales and credit sales. The exact liquidity indicated by the days' sales in receivables and the accounts receivables turnover will be meaningless but the trend that can be determined from these computations will be meaningful.

During times of inflation, which of the inventory costing methods listed below would give the most realistic valuation of inventory? Which method would give the least realistic valuation of inventory? Explain. a. LIFO b. Average c. FIFO

The most realistic valuation of inventory would be the FIFO method the most recent cost would be in the inventory. The LIFO method would result in the least realistic valuation of inventory. This is the result of having old cost in inventory.

Does the allowance method for bad debts or the direct write-off method result in the fairest presentation of receivables on the balance sheet and the fairest matching of expenses against revenue?

The use of the allowance for doubtful accounts approach results in the bad debt expense being charged to the period of sale, thus matching this expense in the period of sale. It also results in the recognition of the impairment of the asset.

List three situations in which the liquidity position of the firm may not be as good as that indicated by the liquidity ratios.

There are many situations where the liquidity position of the firm may not be as good as that indicated by the liquidity ratios. Some of the situations are the following: 1. Notes discounted in which the other party has full recourse against the firm. 2. Guarantee of a bank note for another firm. 3. Major pending lawsuits against the firm 4. A major portion of the inventory is obsolete. 5. A major portion of the receivables are uncollectible.

A company that uses a natural business year, or ends its year when business is at a peak, will tend to distort the liquidity of its receivables when end-of-year and beginning-of-year receivables are used in the computation. Explain how a company that uses a natural business year or ends its year when business is at a peak can eliminate the distortion in its liquidity computations.

This distortion can be eliminated by using the average monthly receivable figures in the liquidity computations. The average monthly receivables figure will eliminate the year's high or low in receivables.

A. B. Smith Company has guaranteed a $1 million bank note for Alender Company. How would this influence the liquidity ratios of A. B. Smith Company? How should this situation be considered?

This guaranteed note would not be recorded by AB Smith Company; therefore, it would not influence the liquidity ratios. The potential impact on the liquidity of AB Smith Company should be considered, because AB Smith Company could be called upon to pay the note. The guaranteed would be disclosed in a footnote to the financial statements.

Arrow Company has invested funds in a supplier to help ensure a steady supply of needed materials. Would this investment be classified as a marketable security (current asset)?

This investment would NOT be classified as a marketable security because there is no intent to sell the securities and use the funds in current operations.

When a firm faces an inflationary condition and the LIFO inventory method is based on a periodic basis, purchases late in the year can have a substantial influence on profits. Comment.

This is true because the most recent purchases end up in cost of goods sold on the income statement.

Why could a current asset such as Net Assets of Business Held for Sale distort a firm's liquidity, in terms of working capital or the current ratio?

This type of a current asset would not be a normal recurring current asset. The firm's liquidity would be overstated in terms of normal sources.

Indicate the single most important factor that motivates a company to select LIFO.

Under inflationary conditions the cash flow under LIFO is greater than the cash flow under the other inventory methods by the difference in the resulting tax between the alternative cost methods.

Jones Wholesale Company has been one of the fastest growing wholesale firms in the United States for the last five years in terms of sales and profits. The firm has maintained a current ratio above the average for the wholesale industry. Mr. Jones has asked you to explain possible reasons why the firm is having difficulty meeting its payroll and its accounts payable. What would you tell Mr. Jones?

When a firm is growing fast, it needs a large amount of funds to expand its inventory and receivables. At the same time, payroll and payables require funds. Although Jones Wholesale Company has maintained an above average current ratio for the wholesale industry, it has probably built up inventory and receivables, which require funds. The inventory and the receivables are probably being carried for longer periods of time than the credit terms received on the payables. Funds may have also been applied from current operations towards long-term assets in order to expand capacity. Fast-growing firms typically do have a problem with a shortage of funds. It is important that they minimize this problem in order to a avoid a bad credit rating and possible bankruptcy.

Explain the influence of the use of LIFO inventory on the inventory turnover.

When prices are rising, the use of LIFO inventory will result in a much higher inventory turnover because of the lower inventory and the higher cost of goods sold. Therefore, the inventory turnover of a firm that uses LIFO should not be compared with the inventory turnover of a firm that does not use LIFO

Some firms do not report the cost of goods sold separately on their income statements. In such a case, how should you proceed to compute days' sales in inventory? Will this procedure produce a realistic days' sales in inventory?

When the cost of good sold is not available to compute days' sales in inventory, use net sales. The result will not be a realistic number of days' sales in inventory, but the result will be useful in comparing one period with another for the same firm and in comparing one firm with another firm, also using net sales.

Define working capital.

Working capital is defined as current assets less current liabilities.

The number of days' sales in inventory relates the amount of the ending inventory to the average daily cost of goods sold. Explain why this computation may be misleading under the following conditions: a. The company uses a natural business year for its accounting period. b. The company closes the year when activities are at a peak. c. The company uses LIFO inventory, and inflation has been a problem for a number of years.

a. If the company uses a natural business year for its accounting period, the number of days' sales in inventory will tend to be understated. When the average daily cost of goods sold for the year is divided into the ending inventory, the resulting answer will be a lower number of days' sales in inventory than actually exists. b. If the company closes the year when the activities are at a peak, the number of days' sales in inventory would tend to be overstated and the liquidity would be understated. When the average daily cost of goods sold for the year is divided into the ending inventory, the resulting answer will be a higher number of days' sales in inventory than actually exists. c. If the company uses LIFO inventory, the number of days' sales in inventory would tend to be understated during inflation because the inventory would be at low cost figures, while the cost of goods sold would be at higher current cost.

The days' sales in inventory is an estimate of the number of days that it will take to sell the current inventory. a. What is the ideal number of days' sales in inventory? b. In general, does a company want many days' sales in inventory? c. Can days' sales in inventory be too low

a. There is no ideal number of days' sales in inventory. The number that a company should have would be guided by company policy and industry average. b. In general, a company wants to minimize the days' sales in inventory. Excess inventory is expensive to the company. Some of these costs are storage cost, additional funds required, and financing cost. c. Days' sales in inventory can be too low, resulting in lost sales, limited production runs, higher transportation costs, etc.