FINANCIAL STATEMENTS, TAXES
AND CASH FLOW
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 non-cash 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 market value.
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 depends.
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.