Chapter 6 Notes - Chapter 6 Notes 1 Current Assets o Any...

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Chapter 6 Notes1.Current Assetso Anyasset expected to be converted to cash within one year or the operating cycle, whichever is longer.o Operating cycle = cashinventorysaleaccounts receivablecash.i.e., cash to cash cycle.o Typical Current Assets arecash, short term investments, accounts/notes receivable, inventory, prepaid expenses.o Current Assets arelisted on the balance sheet in order of liquidity, i.e. how close they are to becoming cash. o Managing current assets important for all companies, but particularly retailers/financial services firms.2.Key Ratios/Calculations involving Current Assets (Solvency Measures)o Working Capital = Current Assets – Current Liabilitieso Current Ratio = Current Assets / Current Liabilitieso Quick Ratio = Cash + Short Term Investments + Receivables / Current Liabilitieso These ratios are very important to lenders and credit rating agencies. Also, it is very typical to see these ratios cited in loan covenants. Finally, auditors know companies with negative working capital are cash poor, or will be soon, and thus are on the lookout for fraud.3.Limitations in the Use of Solvency Measureso As is the case for all financial measures,they are backward looking, and thus not always a good predictor of future cash flows. However, these ratios tend to be more meaningful/useful than most, and generally are a good indicator of future cash flow problems.o These ratios can be affected by the timing of cash payments/receipts at the end of an accounting period, and via this practice (“window dressing”)management can massage the numbers somewhat.4.Cash and Cash Equivalentso First asset listed on the balance sheet, as it iscompletely liquid.o Companies need to focus oncash restrictions/proper management/control of cash.o Note: Cash “like” assets can show up in multiple places on a balance sheet, depending on maturity. If less than 90 days, it’s Cash and Cash Equivalents, >90 days but < 1 year, then it’s Short Term Investments, and if > 1 year, it’s Long Term Investments.5. Cash Restrictionso Restrictions tend to be tied to loans. Generally two types, escrow and compensating balances.o Escrow = cash controlled by a third party (trustee) until a debt is paid.o Compensating Balances = minimum amounts to be kept on deposit at a lender (i.e. bank) while a loan is outstanding.o Restricted cash should besegregated on the balance sheet or described in the footnotes.6. Proper Management o Small amounts of cash forday to day use is maintained inPetty Cash.o Cash by itselfis not considered a particularlyproductive asset, as itsearning power is limited to interest.o An important company tool to manage cash is the cash budget, which is an internal document (i.e. not published for investors or others).

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