Page 586

Questions

10-1 Why is liquidity important in analysis of financial statements? Explain its importance from the
viewpoint of more than one type of user

Liquidity is an indicator of an entity's ability to meet its current obligations. An entity in a weak short-term
liquidity position will have difficulty in meeting short-term obligations. This has implications for any
current and potential stakeholders of a company. For example, tack of liquidity would affect users'
analysis of financial statements in the following ways:

a) Equity investor: In this case, the company likely is unable to avail itself of favorable
discounts and to take advantage of profitable business opportunities. It could even mean
loss of control and eventual partial or total loss of capital investment.

b) Creditors: In this case, delay in collection of interest and principal due would be
expected and there is a possibility of the partial or total loss of the amounts due them.

10–11. Since cash generally does not yield a return, why does a company hold cash?

Cash inflows and cash outflows are not perfectly predictable. For example, in the case of a business
downturn, sales can decline more rapidly than do outlays for purchases and expenses. The amount of
cash held is in the nature of a precautionary reserve, which is intended to take care of short-term
surprises in cash inflows and outflows.

10–13. What are management’s objectives in determining a company’s investment in inventories and
receivables?

Management's major objectives in determining the amounts invested in receivables and inventories
include the promotion of sales, improved profitability, and the efficient utilization of assets.

10–46. In computing the earnings to fixed charges ratio, what broad categories of items are included in
fixed charges? What tax adjustments must be considered for these items?

Fixed charges can be defined narrowly to include only interest and interest equivalents or broadly
to include all outlays required under contractual obligations specifically:

(a) Interest and interest equivalents:

i. Interest on long-term debt (including amortization of any discounts and premiums). ii. Interest

element included in long-term lease rentals.

iii. Capitalized interest.

(b) Other outlays under contractual obligations:

i. Interest on income bonds (assuming profitable operations-implicit assumption in such

borrowings).

ii. Required deposits to sinking funds and principal payments under serial bond obligations.

iii. Principal repayments included in lease obligations.

iv. Purchase commitments under noncancelable contracts to the extent that requirements
exceed normal usage.
 v. Preferred stock dividend requirements of majority-owned subsidiaries.

vi. Interest on recorded pension liabilities.

vii. Guarantees to pay fixed charges of unconsolidated subsidiaries if the requirement to honor the
guarantee appears imminent.

(C) Other fixed charges-such as imputed interest in the case on non-interest or low interest-
bearing obligations. These are not periodical fund drains.

For each of the above categories, the corresponding income to be included in the ratio computation
should be adjusted accordingly. Regarding fixed charges, those items not tax deductible must be
tax adjusted. This is done by increasing them by an amount equal to the income tax that would be
required to obtain an after-tax income sufficient to cover the fixed charges. The tax rate to be used
should be based on the relation of the taxes on income from continuing operations to the amount of
pre-tax income from continuing operations-the company's effective tax rate.

10–49. Company B is a wholly owned subsidiary of Company A. Company A is also Company B’s
principal customer. As a potential lender to Company B, what particular facets of this relationship
concern you most? What safeguards, if any, do you require in any loan contract?

Since Company B is under the control of Company A, the latter can siphon off funds from it to the
detriment of B's creditors. Moreover, the customer-supplier relationship with Company A means that
Company A has considerable discretion in the allocation of revenues, costs, and expenses among the
two entities in such a way as to determine which company will show what portion of the total available
income. This again can work to the detriment of Company B's creditors. As a lender to Company B, one
would want to write into the lending agreement conditions that would prevent parent Company A from
exercising its controlling powers to the detriment of the lender.

Page 588

EXERCISE 10–1

The Lux Company experiences the following unrelated events and transactions during Year 1

The company’s existing current ratio is 2:1 and its quick ratio is 1.2:1.

1. Lux wrote off $5,000 of accounts receivable as uncollectible.

2. A bank notifies Lux that a customer’s check for $411 is returned marked insufficient funds. The
customer is bankrupt.

3. The owners of Lux Company make an additional cash investment of $7,500.

4. Inventory costing $600 is judged obsolete when a physical inventory is taken.

5. Lux declares a $5,000 cash dividend to be paid during the first week of the next reporting period. 6.
Lux purchases long-term investments for $10,000.

7. Accounts payable of $9,000 are paid.

8. Lux borrows $1,200 from a bank and gives a 90-day, 6% promissory note in exchange.

9. Lux sells a vacant lot for $20,000 that had been used in its operations. 10. A three-year insurance
policy is purchased for $1,500.
Required: Separately evaluate the immediate effect of each transaction on the company’s:

a. Current ratio.

b. Quick (acid-test) ratio.

c. Working capital.

Current Ratio Quick Ratio Working Capital

1.' No change No change No change

2. No change No change No change

3. Increase Increase Increase

4. Decrease No change Decrease

5. Decrease Decrease Decrease

6. Decrease Decrease Decrease

7. Increase Increase No change

8. Decrease Decrease No change

9. Increase Increase Increase

10. No change Decrease No change

EXERCISE 10–2

Interpret the effect of the following six independent events and transactions for each of the following:

a. Accounts receivable turnover (currently equals 3.0).

b. Days’ sales in receivables.

c. Inventory turnover (currently equals 3.0).

The three columns to the right of each event and transaction are identified as (a), (b), and (c)
corresponding to the three liquidity measures. For each event and transaction indicate the effect as an
increase (I), decrease (D), or no effect (NE).

Events and Transactions (a) (b) (c)

1. Beginning inventory understatement of $500 is corrected this period. NE NE NE
2. Sales on account are underreported by $10,000 NE NE D
3. $10,000 of accounts receivable are written off by a charge to the NE NE I
allowance for doubtful accounts
4. $10,000 of accounts receivable are written off by a charge to bad NE NE I
debts expense (direct method).
5. Under the lower-of-cost-or-market method, inventory is reduced to NE NE I
market by $1,000.
6. Beginning inventory overstatement of $500 is corrected this period. I D NE
Page 590

EXERCISE 10–6

The following information is relevant for Questions 1 and 2: Austin Corporation’s Year 8 financial
statement notes include the following information:

a. Austin recently entered into operating leases with total future payments of $40 million that equal a
discounted present value of $20 million.

b. Long-term assets include held-to-maturity debt securities carried at their amortized cost of $10
million. Fair market value of these securities is $12 million.

c. Austin guarantees a $5 million bond issue, due in Year 13. The bonds are issued by Healey, a
nonconsolidated 30%-owned affiliate

After analysis, you decide to adjust Austin’s balance sheet for each of the above three items.

1. Among the effects of these adjustments for the times interest earned coverage ratio is (choose one of
the following):

a. Lease capitalization increases this ratio.

 b. Lease capitalization decreases this ratio.

c. Recognizing the debt guarantee decreases this ratio.

d. Held-to-maturity debt securities adjustment increases this ratio.

2. Among the effects of these adjustments for the long-term debt to equity ratio is (choose one of the
following):

 Only the held-to-maturity debt securities adjustment decreases this ratio.

b. Only lease capitalization decreases this ratio.

c. All three adjustments decrease this ratio.

d. All three adjustments increase this ratio.

3. What is the effect of a cash dividend payment on the following ratios (all else equal)?

Times Interest Earned Long-Term Debt to Equity

a. Increase Increase

 b. No effect Increase

c. No effect No effect

d. Decrease Decrease

4. What is the effect of selling inventory for profit on the following ratios (all else equal)?
 Times Interest Earned Long-Term Debt to Equity

a. Increase Increase

 b. Increase Decrease

c. Decrease Increase

d. Decrease Decrease

5. The existence of uncapitalized operating leases is to (choose one of the following):

a. Overstate the earnings to fixed charges coverage ratio.

b. Overstate fixed charges.

c. Overstate working capital.

 d. Understate the long-term debt to equity ratio

page 591

PROBLEMS

PROBLEM 10–1 Analyzing Measures of Short-Term Liquidity Campbell Soup

Refer to the financial statements of Campbell Soup Company in Appendix A.

Required: a. Compute the following liquidity measures for Year 10:

(1) Current ratio.

Current assets $ 1,665.5

************ = ******* = 1.28
Current liabilities $ 1,298.1

(2) Acid-test ratio.

Current assets – Inventory – Prepaid Expenses $ 1,665.5 - $ 819.8 - $ 118.0

************************************** = ************************ = 0.56
Current liabilities $ 1,298.1

(3) Accounts receivable turnover (accounts receivable balance at end of Year 9 is $564.1).

Net credit sales $6,205.8

*********************** = ********* = 10.44
Average accounts receivables ($624.5 + $564.1) /2

(4) Inventory turnover (inventory balance at end of Year 9 is $816.0).

Cost of goods sold $4,258.2

*************** = ************** = 5.21
Average inventory ($819.8 + $816.0)/2

(5) Days’ sales in receivables.

 Accounts receivables $624.5
****************** X 360 = ******* = 36.23
Total credit sales $6,205.8

(6) Days’ sales in inventory.

$819.8
********** = 69.31
($4,258.2/360)

(7) Conversion period (operating cycle).

36.23 + 69.31 = 105.54

(8) Cash and cash equivalents to current assets.

($80.7 + $22.5)
************* = 0.062
$1,665.5

9) Cash and cash equivalents to current liabilities.

($80.7 + $22.5)
************* = 0.0795
$1298.1

(10) Days’ purchases in accounts payable.

Ending inventory 5 819.8

+Cost of goods sold 4,258.2

- Beginning inventory 816.0

- Depreciation 184.1

=Purchases 54,077.9

($525.2
************ = = 46.36
($4,077.360)

(11) Net trade cycle.

105.54 - 46.36 = 59.18

(12) Cash flow ratio.

$448.41

************* = 34.54%

51,298.1

b. Assess Campbell’s liquidity position using results from (a).

. Campbell's liquidity position is excellent for a couple of reasons. First, the company has adequate
current assets relative to current liabilities as evidenced by its current and acid-test ratios. Second,
the company earns consistent sales and collects on receivables as evidenced by its receivables
turnover. Consequently, the company generates abundant cash to supplement its current assets.

c. For Year 10, compute ratios 1, 4, 5, 6, and 7 using inventories valued on a FIFO basis (FIFO
inventory at the end of Year 9 is $904).

Current assets using FIFO = $1,665.5 + 584.6 = $1,750.1

COGS (FIFO) = COGS (LIFO) + L1FO reserve

= 54,258.2 + [584.6 - (S904 - S816)) = $4,254.8

1. $1,750.1/ $1,298.1 = 1.35

4. $4,254.81 / ($ 904.4 + $ 904)/2] = 4.71

5. $624.5 / ($6,205.8 / 360) = 36.23

6. $904.4 / ($4,258.2 / 360) = 76.46

7. 36.23 + 76.46 = 112.69

d. What are the limitations of the current ratio as a measure of liquidity?

Disregarding, for purposes of this analysis, the prepaid expenses and similar unsubstantial items
entering the computation of the current ratio, we are left with the four major elements that comprise
this ratio-those are cash, accounts receivable, inventories, and current liabilities. If we define
liquidity as the ability to balance required cash outflows with adequate inflows, including an
allowance for unexpected interruptions of inflows or increases in outflows, we must ask: Does the
relation of these four elements at a given point in time:

1. Measure and predict the pattern of future fund flows?

 2. Measure the adequacy of future fund inflows in relation to outflows?

unfortunately, the answer to both of these questions is primarily no. The current ratio is a static
concept of what resources are available at a given moment in time to meet the obligations at that
moment. The existing reservoir of net funds does not have a logical or causal relation to the future
funds that will flow through it. Yet it is the future flows that are the subject of our greatest interest in
the assessment of liquidity. These flows depend importantly on elements not included in the ratio
itself, such as sales, profits, and changes in business conditions. There are at least three
conclusions that can be drawn:

1. Liquidity depends to some extent on cash or cash equivalents balances, but to a much
more significant extent on prospective cash flows.

2. There is no direct or established relation between balances of working capital items and the
pattern that future cash flows are likely to assume.

3. Managerial policies directed at optimizing the levels of receivables and inventories are mainly
directed towards efficient and profitable asset utilization and only secondarily towards liquidity.

These conclusions obviously limit the value of the current ratio as an index of liquidity.
Moreover, given the static nature of this ratio and the fact that it consists of items that affect liquidity
in different ways, we must exercise caution in using this ratio as a measure of liquidity

e. How can analysis and use of other related measures (other than the current ratio) enhance the
evaluation of liquidity?

e. Accounts receivable turnover rates or collection periods can be compared to industry averages
or to the credit terms granted by the company. When the collection period is compared with the
terms of sale allowed by the company, the degree to which customers are paying on time can be
assessed. In assessing the quality of receivables, the analyst should remember that a significant
conversion of receivables into cash, except for their use as collateral for borrowing, cannot be
achieved without a cutback in sales volume. The sales peuey aspect of the collection period
evaluation must also be kept in mind. A company may be willing to accept slow-paying customers
who provide business that is, on an overall basis, profitable; that is, the profit on sale compensates
for the extra use by the customer of the company funds. This circumstance may mOdify the
analyst's conclusions regarding the quality of the receivables but not those regarding their
liquidity.

The current ratio computation views its current asset components as sources of funds that can,
as a means of last resort, be used to payoff the current liabilities. Viewed this way, the inventory
turnover ratios give us a measure of the quality as well as of the liquidity the inventory component of
the current assets. The quality of inventory is a measure of the company's ability to use it and
dispose of it without loss. When this is envisaged under conditions of forced liquidation, then
recovery of cost is the objective. In the normal course of business, the inventory should, of course,
be sold at a profit. Viewed from this point of view, the normal profit margin realized by the company
assumes importance because the funds that will be obtained, and that would theoretically be
available for payment of current liabilities, will include the profit in addition to the recovery of cost. In
both cases, costs of sales will reduce net proceeds. In practice, a going concern cannot use its
investment in inventory for the payment of current liabilities because any drastic reduction in normal
inventory levels will surely cut into the sales volume. The turnover ratio is a gauge of liquidity in that
it conveys a measure of the speed with which inventory can be converted into cash. In this
 connection, a useful additional measure is the conversion period of inventories.

Page 594

PROBLEM 10–7 Calculating Solvency Ratios

Refer to the financial statements of Campbell Soup Company in Appendix A. Required:

a. Compute the following measures for Year 10. (Assume 50% of deferred income taxes will
reverse in the foreseeable future—the remainder should be considered equity.)

Long-term debt

Notes payable $ 792.9

Capital lease obligations 12.9

Long-term debt [172] 805.5

Deferred income taxes (50%) [176] 117.6

Other Liabilities [177] 28.5

Current Liabilities [45] 1298.1

Total debt $2,250.0

Equ ity Capital

Owners' equity [54] $1,691.8

Deferred income taxes (50%) [176] 117.6

Minority interests [17S] 56.3

Total equity $1,865.7

(1) Total debt to equity.

 $2,250.0/ $1,865.7 = 1.21

(2) Total debt to total assets.

$2,250.0/ $4,115.6 = 0.55

(3) Long-term liabilities to equity.

($805.8 + $117.6 + $28.5) / $1,865.7 = 0.51

(4) Total equity to total liabilities.

$1,865.7/ $2,250.0 = 0.83

(5) Fixed assets to equity.

$ 1,717.7/ $1,865.7 = 0.92

(6) Short-term liabilities to total debt.

$1,298.1 / $2,250.0 = 0.58

(7) Earnings to fixed charges.

Interest expense 111.6 --

Int. with oper. leases (1/3 of $S2.4) 20.8 20.8

Interest incurred 121.9

Undistributed equity in earnings in non-

consolidated subs. [169A] ($13.0- $7.4) (5.6) 0.0

306.2 142.7

(8) Cash flow to fixed charges.

Cash from ops before tax' 619.5 --

Interest expense 111.6 --

Interest incurred -- 121.9

Interest portion of op leases 20.8 20.8

751.9 142.7

• CFO $ 448.4 + Current tax expense $171.1 = $619.5

Ratio = $751.9 / $142.7 = 5.27

 (9) Working capital to total debt.
$367.4/52,250.0 = 0.16

b. Under the heading “Balance Sheets” in its Management’s Discussion and Analysis section, Campbell
refers to the ratio of total debt to capitalization (33.7%). Verify Campbell’s computation for Year 10.

b. We would compute the total debt to total capitalization as follows:

$805.8 + $28.5+ $235.1]

38.0%
$1,069.4 + $1,691.8 + $56.3
 (a) Long-term debt

(b) Other liabilities

(C) Deferred income taxes (assuming 100% considered as liabilities)

(d) a + b + C

(e) Total equity

(I) Minority interests

Probably the closest we can come to reconstruct Campbell's computation of 33.7%, is as follows:
($805.8 + 528.5) I (5834.3 + 51,691.8) = 33%. This computation omits deferred taxes and minority
interests.

Page 596

PROBLEM 10–9 Computing and Analyzing Earnings Coverage Ratios

The income statement of Lot Corp. for the year ended December 31, Year 1, follows:
Additional Information:

1. The following changes occurred in current assets and liabilities for Year 1:

Current accounts Increase (decrease) Current accounts Increase (decrease)

Accounts receivable . . . . . . . . . $(1,600) Notes payable . . . . . . . . . . . . $ (400)

Inventories . . . . . . . . . . . . . . . . 2,000 Accounts payable. . . . . . . . . . 2,000
Dividend payable . . . . . . . . . . . 240

2. Tax rate is 40%.

Required:

a. Compute the following earnings coverage ratios:

(1) Earnings to fixed charges.

Numerator Denominator

Pre-tax income $
$5,800

Int. incurred - int. capitalized (880+340-120) 1,100 1,220

Amortization of bond discount 100 100

Interest portion of rental expense 400 400

Amortization of prior capitalized interest 100 --

Undistributed inc. of <50% owned affiliates (400) --

Share of minority interest 600 --

$7,700 $1,720
Ratio = $7,700 I $1,720 = 4.48

(2) Cash flow to fixed charges.

Add back expenses not requiring cash:

Depreciation (includes amortization of

previously capitalized interest) 1,200 --

Amortization of bond discount 100 100

Share of minority interest 600 --

Deferred taxes-already added back -- --

Increase in inventories (2,000) --

Decrease in accounts receivable 1,600 --

Increase in accounts payable 2,000 --

Less Undistributed income of affiliates (400) --

Pre-tax cash provided by operations 8,900 --

Interest expensed-bond discount add back 1,100 --

I nterest portion of rental expense 400 400

Interest incurred 1,220

$10,400 $1,720

Ratio = $10,4001 $1,720 = 6.04

(3) Earnings coverage of preferred dividends.

3. Earnings Coverage of Preferred Dividends:

Ratio = $7,7001 {$1,720 + [$400/(1 - .40)]} = 3.23

b. Analyze and interpret the earnings coverage ratios in (a).

The company's coverage ratios suggest the existence of sufficient earnings and cash
flows to cover its fixed charges. There is no evidence of concern from any of these three
coverage ratios. For a more complete analysis, we would want to collect values from
other firms (competitors) and additional prior years for comparative analyses.