FINANCIAL STATEMENTS, TAXES, AND CASH FLOWS
Answers to Concepts Review and Critical Thinking Questions
Liquidity measures how quickly and easily an asset can be converted to cash without significant loss in
value. It’s desirable for firms to have high liquidity so that they have a large factor of safety in meeting
short-term creditor demands. However, since liquidity also has an opportunity cost associated with it—
namely that higher returns can generally be found by investing the cash into productive assets—low
liquidity levels are also desirable to the firm. It’s up to the firm’s financial management staff to find a
reasonable compromise between these opposing needs.
The recognition and matching principles in financial accounting call for revenues, and the costs associated
with producing those revenues, to be “booked” when the revenue process is essentially complete, not
necessarily when the cash is collected or bills are paid. Note that this way is not necessarily correct; it’s the
way accountants have chosen to do it.
Historical costs can be objectively and precisely measured whereas market values can be difficult to
estimate, and different analysts would come up with different numbers. Thus, there is a tradeoff between
relevance (market values) and objectivity (book values).
Depreciation is a noncash deduction that reflects adjustments made in asset book values in accordance with
the matching principle in financial accounting. Interest expense is a cash outlay, but it’s a financing cost,
not an operating cost.
Market values can never be negative. Imagine a share of stock selling for –$20. This would mean that if
you placed an order for 100 shares, you would get the stock along with a check for $2,000. How many
shares do you want to buy? More generally, because of corporate and individual bankruptcy laws, net
worth for a person or a corporation cannot be negative, implying that liabilities cannot exceed assets in
For a successful company that is rapidly expanding, for example, capital outlays will be large, possibly
leading to negative cash flow from assets. In general, what matters is whether the money is spent wisely,
not whether cash flow from assets is positive or negative.
It’s probably not a good sign for an established company, but it would be fairly ordinary for a start-up, so it
For example, if a company were to become more efficient in inventory management, the amount of
inventory needed would decline. The same might be true if it becomes better at collecting its receivables.
In general, anything that leads to a decline in ending NWC relative to beginning would have this effect.