Quality of Assets and the Relative Amount of Debt Although a satisfactory level of earnings may be a good indication of the company’s long-run ability to pay its debts and dividends, we must also look at the composition of assets, their condition -and liquidity, the timing of repayment of liabilities, and the total amount of debt outstanding,
A company may be profitable and yet be unable to pay.its liabilities on time; sales and earnings may appear satisfactory, but plant and equipment may be deteriorating because of poor maintenance policies; valuable patents may be expiring; substantial losses may be imminent due to slow-moving inventories and past-due receivables:
Companies with large amounts of debt often are vulnerable to increases in interest rates and to even temporary reductions in cash inflows. Impact of Inflation During a period of significant inflation, financial statements prepared in terms of historical costs do not reflect fully the economic resources or the real income (in terms of purchasing power) ‘of a business enterprise.
The,FASB recommends that companies include in their annual reports supplementary schedules showing the effects of inflation on their financial statements. Inclusion of these supplementary disclosures is voluntary. not mandatory. Most companies do not include these supplementary schedules because of the high cost of developing this information, as well as the fact that users of financial statements do not generally find the information to be particularly useful. Liquidity refers to a company’s ability to meet its continuing obligations as they arise. For example, a company may have borrowed money and must make quarterly interest and principal payments to a financial institution.
A company may purchase its inventory and other necessities on credit and pay the seller within 30 days of the purchase date. We have emphasized throughout this text the importance to investors, creditors. and other users of financial statements of information that permits them to assess the amount. timing, and uncertainty of future cash flows from the enterprise to them.
As a result, analyzing an enterprise’s liquidity and its credit risk is very important and is a natural place for us to start our study of analyzing financial statements. In this section we learn about ways to assess liquidity, starting with the classified balance sheet and then looking at a number of ratios that are commonly used to glean information about liquidity from the financial statements.
A Classified Balance Sheet In a classified balance sheet, assets usually are presented in three groups: (I) current assets, (2) plant and equipment, and (3) ocher assets. Liabilities are classified into two categories: (l) current liabilities and (2) long-term debt. A classi tied balance sheet for Computer Barn appears on page 618. The classifications current assets-and current liabilities are especially useful in evaluating the short-term liquidity-or solvency-of the business entity.
Current Assets Current assets are relatively liquid resources. This category includes cash, investment.s in marketable securities, receivables, inventories. and prepaid expenses.
To qualify as a current asset, an asset must be capable of being converted into cas” or used up within a relatively short period of time, without interfering with normal business operations.Current assets are tied to an enterprise’s operating cycle.
Most companies have several operating cycles within a year. This means that they take cashand purchase inventory, sell the inventory,and collect the receivable in cash several times within a year. for these companies, the time period used to identify current assets is one year, so any asset that is expected tobe converted into cash within.one year is classified as ‘a current asset in the enterprise’s balance sheet. Some enterprises, however, have relatively long operating cycles.
For example, a company that constructs very large items (for example, airplanes or ships) may have a production period that extends well beyond one year. In these cases, the length of the company’s operating cycle is used to define those assets that are classified as current. While most current assets are exoected to be converted into cash, we also include as current assets those that will be up or consumed during the year or operating cycle, if longer.
For example, prepaid expenses are classified as current assets on the basis that their having been paid in advance preserves cash that otherwise would have to be paid in the current period. Combining these ideas, current assets can be defined as assets that are expected to be converted into cash or used up within the next year or operating cycle, whichever is longer. In a balance sheet, current assets are listedin order of liquidity.
(The Closer an asset is to becoming cash, the greater its liquidity.) Thus cash always is listed first among the current assets, usually followed by investments in marketable securities, receivables, inventory, and prepaid expenses, in that order. Current L1abllltle. ‘Current liabilities are existing debts that are expected to be satisfied by using the enterprise’s current assets.
Among the most common current liabilities are notes payable (due within one year), accounts payable, .uneamed revenue, and accrued expenses, such as income taxes payable, salaries payable, or interest payable. In the balance sheet, notes payable usually are listed first, followed by accounts payable; other types of current liabilities may be listed in any sequence. . The relatiosship between current assets and current liabilities is as important as the total.dollar amount in either category.
Current liabilities must be paid inthe near future, and the cash to pay these liabilities will come from current assets. Thus decision makers evaluating the short-term liquidity of a business often compare the relative amounts of current assets and current liabilities, whereas an evaluation of long-term credit risk requires a comparison of total assets to total liabilities.
We will now use Computer Barn’s classified balaace sheet to examine some widely applied measures of short-term liquidity and long-term credit risk.