Analyzing Investing Activities

Current Asset Introduction 

Current (Short-term) Assets - Resources or claims to resources that are expected to be sold, collected, or used within one year or the operating cycle, whichever is longer.

Noncurrent (Long-term) Assets - Resources or claims to resources that are expected to yield benefits that extend beyond one year or the operating cycle, whichever is longer.

Cash, Cash Equivalents and Liquidity

Cash - Currency, coins and amounts on deposit in bank accounts, checking accounts, and some savings accounts.

Cash Equivalents - Short-term, highly liquid investments that are: Readily convertible to a known cash amount. Close to maturity date and not sensitive to interest rate changes.

Analysis of Cash and Cash Equivalents 

 Companies risk a reduction in liquidity should the market value of short-term investments decline.

 Cash and cash equivalents are sometimes required to be maintained as compensating balances to support existing borrowing arrangements or as collateral for indebtedness.

Receivables

Receivables are amounts due from others that arise from the sale of goods or services, or the loaning of money

Accounts receivable refer to oral promises of indebtedness due from customers

Notes receivable refer to formal written promises of indebtedness due from others 

Receivables are reported at their net realizable value — total amount of receivables less an allowance for uncollectible accounts

Management estimates the allowance for uncollectibles based on experience, customer fortunes, economy and industry expectations, and collection policies 

Analyzing Receivables

Assessment of earnings quality is often affected by an analysis of receivables and their collectibility

Analysis must be alert to changes in the allowance—computed relative to sales, receivables, or industry and market conditions.

Two special analysis questions:

    (1) Collection Risk

Review allowance for uncollectibles in light of industry conditions

Apply special tools for analyzing collectibility:

• Determining competitors’ receivables as a percent of sales—vis-à-vis the   company under analysis

• Examining customer concentration—risk increases when receivables are   concentrated in one or a few customers

• Investigating the age pattern of receivables—overdue and for how long

• Determining portion of receivables that is a renewal of prior receivables

• Analyzing adequacy of allowances for discounts, returns, and other credits 

    (2) Authenticity of Receivables

      Review credit policy for changes

      Review return policies for changes

      Review any contingencies on receivables

Securitization of Receivables 

Securitization (or factoring) is when a company sells all or a portion of its receivables to a third party

Receivables can be sold with or without recourse to a buyer (recourse refers to guarantee of collectibility)

Sale of receivables with recourse does not effectively transfer risk of ownership

For securitizations with any type of recourse, the seller must record both an asset and a compensating liability for the amount factored

For securitizations without any recourse, the seller removes the receivables from the balance sheet

Prepaid Expenses

Prepaid expenses are advance payments for services or goods not yet received that extend beyond the current accounting period—examples are advance payments for rent, insurance, utilities, and property taxes

Analysis of Prepaids

Two analysis issues:

(1) For reasons of expediency, noncurrent prepaids sometimes are included among prepaid expenses classified as current--when their magnitude is large, they warrant scrutiny

(2) Any substantial changes in prepaid expenses warrant scrutiny 

Inventories

Definitions

Inventories are goods held for sale, or goods acquired (or in process of being readied) for sale, as part of a company’s normal operations

Expensing treats inventory costs like period costs—costs are reported in the period when incurred

Capitalizing treats inventory costs like product costs—costs are capitalized as an asset and subsequently charged against future period(s) revenues benefiting from their sale 

Use of Inventory Methods in Practice

LIFO Liquidations

(1) Companies maintain LIFO inventories in separate cost pools.

(2) When inventory quantities are reduced, each cost layer is matched against current selling prices.

(3) In periods of rising prices, dipping into lower cost layers can inflate profits.

Analyzing Inventories—Restatement of LIFO to FIFO

Three step process:

1.  Reported LIFO Inventory + LIFO reserve
2.  Deferred tax payable + [LIFO reserve x Tax rate]
3.  Retained earnings + [LIFO reserve x (1-Tax rate)]

LIFO reserve is the amount by which current cost exceeds reported cost of LIFO inventories