Questions and answers
10–5. Are all inventories included in current assets? Why or why?
No. Not all inventories but some of them should be included in the current assets .This is because not all inventories can be sold to generate cash for the company’s use for the Company’s normal operations. An ordinary problem can be due the obsolescence of the company’s stock, where the company may take longer period more than one financial year to sell or dispose such stocks. Therefore, the balance sheet value of inventory should include the amount which can be recovered when they are finally sold.
10–9. Your analysis of two companies reveals identical levels of working capital. Are you confident in concluding their liquidity positions are equivalent?
As much as the level of working capital for the two companies is equivalent, the equity risk for the second company is greater than the first company. This is because the preference shares for the second company constitute 30% of financing value while the first company constitutes 20% of the financing value. Therefore, in relation to accounting prudence the working capital for the second company is lower than for the first company. This suggests that the first company is in good liquidity position compared to the second company.
10–17. How can we measure “quality” of current asset?
The best quality current asset determines the Company’s better liquidity ratio and the ability for the company to meet the short-term obligations. The shorter the time the current asset is able to generate the cash for the company’s normal operations, the better the quality of such current asset. Equally important, the current asset must be able to generate sufficient cash within a maximum of one financial year or within one operating business cycle. Therefore, if the company has high current ratio it means such a company has high maximization rate on current asset compared to the current liabilities.
10–25. What is window-dressing of current assets and liabilities? How can we recognize whether financial statements are window-dressed?
Window-dressing is fundamentally a special financial statement adjustments made in end of year financial reports in order to give the company a better financial look or appearance before representing them to the prospective shareholders.
For us to recognize that such adjustments were made, we must be in a position to analyze the company’s financial statements. For instance, if IMC’s end of the year current assets is $1,600,000 and the current liabilities are $400,000, the current ratio would be $1,600,000/$400,000 which equal to 4:1.To improve its current ratio for the annual report in order to attract lenders, they window dresses by paying off say $40,000 as current debt. This would translate to a current asset of $1,560,000 and a current liability of $360,000.The resulting current ratio, 4.3:1, would be misleading. To capture the misleading information, we will observe that the company will borrow an additional short-term financial instrument that will reduce the current ratio for the next accounting year. And consequently, the current ratio would temporarily to change.
10–50. Comment on the assertion: “Debt is a supplement to, not a substitute for, equity financing.”
Debt financing is a supplement that acts as leverage or a financial back-up for a company. It involves borrowings from financial institution in order to relinquish the cash profits in a company. For instance, when the IMC Inc. borrows the loan, it increases the cash flow thus escalating the current ratio; vividly it becomes portentous for considerable marginal safety. Another advantage behind the debt financing is that, the company retains full ownership of the business after the pay-back period. Besides, the company builds up the good credit profile since such amount payable is tax-deductable. This is contrary to equity financing where the stakeholder injects his own cash into the company. This means that the stakeholder will be entitled to the profits of the company and also the interest. Therefore, the debt is fundamentally a supplement other than a substitute to the equity financing.