INTERMEDIATE ACCOUNTING 1 By using the practice of ratio analysis, an
analyst can determine how good a
ASSET company is at using its assets to generate
is an economic resource that can be owned, wealth for shareholders.
and is expected to provide future
economic benefits. • Return on Assets (ROA) & Return on
Net Assets (RONA)
Common asset categories include measures of how much profit is generated
1. cash and cash equivalents by a company's assets.
2. accounts receivable
3. inventory Return on Assets (ROA)
4. prepaid expenses is a financial ratio that can help analyze the
5. property and equipment. profitability of a company. ROA measures
the amount of profit a company generates
Notes: as a percentage relative to its total assets.
Not all assets are tangible. Trademarks
and patents are examples of intangible Formula: Net Income
assets. Assets
Assets are presented on the balance
sheet in order of their liquidity. Return on Assets (RONA)
Assets create or preserve wealth, is a metric which measures a company's
financial performance with regard to fixed
assets combined with working capital.
LONG-TERM/FIXED ASSETS
are expected to be consumed or converted Formula: Net Income
to cash after one year's time, and they are Fixed Assets + Working Capital
listed on the balance sheet beneath current
assets. Working Capital = current assets – current
liabilities
INVESTORS
any person or other entity who commits • Current Ratio, Quick Ratio, & Acid-Test
capital with the expectation of receiving Ratio
financial returns. measures of a company's ability to meet
short term obligations.
Common asset classes for individual
investors include: Current Ratio
1. stocks is a commonly-used financial ratio. It tells
2. bonds investors and analysts whether a company
3. cash is able to pay its current liabilities with its
4. foreign currencies current assets (typically within a 12-month
5. collectibles period).
6. precious metals
7. real estate Formula: Current Assets
8. commodities. Current Liabilities
PORTFOLIO Quick Ratio or Acid-test Ratio
is a collection of assets The quick ratio (also known as the acid-test
ratio) offers insight into how well a company
ASSET ALLOCATION can meet its short-term obligations. It
is an investment strategy that aims to shows how quickly a company can convert
balance risk and reward by apportioning a short term assets to pay short term
portfolio's assets according to an liabilities. Essentially, it’s a measure of
individual's goals, risk tolerance, company liquidity.
and investment horizon.
Formula 1:
Cash + Marketable Securities + A/R
Current liabilities
Formula 2: Current Assets - Inventory 2. Accounts Receivable
Current Liabilities Overdue or uncollectible invoices can
reduce current assets and liquidity and
YEAR cause a drag on cash flows.
In the business world, a year is a 12-month
period, four-quarter period, or 13-period 3. Working Capital
stretch of time. determines how much money a company
can put towards its financial obligations and
Notes: its financing of operations.
Yearly information is useful in looking
for trends or measuring performance CASH
against goals. the amount of actual money a business has
Comparing year-over-year information at its disposal.
among companies with different fiscal-
year start dates can distort an analysis examples of cash at the corporate level
The extra day in leap years may also typically include:
distort comparisons 1. Bank accounts
2. Money market funds
CURRENT ASSETS
is a company's cash and its other assets Notes:
that are expected to be converted to cash The amount of cash a company holds
within one year of the date appearing in the is very important and has implications
heading of the company's balance sheet. for the company's overall operating
strategy.
Examples of current assets: High cash reserves also could indicate
1. Cash and cash equivalents (which that management has not figured out
includes currency, checking accounts, petty how to best deploy the cash, but for
cash, Treasury Bills) capital-intensive companies, high cash
2. Temporary investments reserves could signal that the company
3. Accounts receivable is "saving up" to make some
4. Inventory significant purchases.
5. Supplies There is an opportunity cost to holding
6. Prepaid expenses cash; that cost is the return on equity
7. Notes Receivable that company could have earned by
investing the cash in a new product or
Notes: expanding business.
key component of a company's
working capital and the current ratio. Marketable Securities
they provide insight into the amount of are financial instruments that can be sold or
cash the company has access to and converted into cash (at reasonable value)
determines its ability to meet financial within one year. Highly liquid investments
obligations. that are generally issued by businesses to
It also indicates how the company raise funds for operating expenses or
funds its ongoing, day-to-day expansion.
operations, and how liquid a firm is.
help evaluate the value and risk of an Treasury Bills
operation by determining its liquidity is short-term debt issued and backed by
position the full faith and credit of the United States
government.
LIMITATIONS OF CURRENT ASSETS
1. Inventory Marketable securities and Treasury bills
inventory should be relatively easy to are easily converted into cash and are
convert into cash. If inventory cannot be usually called "cash equivalents."
sold, the company may be forced to sell at
a loss, reducing their current assets and, Balance Sheet
therefore, their liquidity. shows the amount of cash at a given point
in time
Statement of Cash Flows prompt recording of the accounts
explains the change in cash over time. receivable leads to receiving the payments
on time from the customers.
ACCOUNTS RECEIVABLE
is the money that a business has a right to ACCOUNTS RECEIVABLE
receive after a certain period of time when MANAGEMENT
the business has sold goods or services on is the process of ensuring thatcustomers
credit. pay their dues on time.
Notes:
are amounts owed by customers for goods helps the businesses to prevent
and services a company allowed the themselves from running out of
customer to purchase on Credit working capital at any point of time.
prevents overdue payment or non-
Notes: payment.
The word receivable stands for the builds the businesses financial and
amount of payment not received. liquidity position.
As accounts receivables form a major also involves identifying the reasons for
part of the organization’s asset, it leads such delays and finding a solution to
to the generation of cash in-flow in the those issues
books of the organization.
it is to be added to the assets in the Process in Accounts Receivable
financial statement of the business. Management:
The accurate record keeping of this 1. Credit Rating - reviewing of the paying
money that is receivable (accounts ability of the customer
receivable) in the books of accounts 2. Continuously monitoring any risk of non-
are required to avoid any default in the payment or delay in receiving the payments
payment due. 3. Maintenance of the customer relations to
reduce Bad Debts
Few pointers connected to recording 4. Addressing the complaints of the
accounts receivable are as follows : customers
A. Establishing the practice of credit 5. Reducing balance of particular accounts
transactions receivable after receiving payments
- this practice of credit facility requires two 6. Preventing any bad debts of the
parties to come to an agreement on the receivables outstanding during a particular
terms and conditions for such credit period.
transactions.
- verifying of the paying ability of the ACCOUNTS RECEIVABLE FINANCING
customer before agreeing to any terms and s a method of selling receivables in order to
conditions. obtain cash for company operations.
B. Generating invoices for the Accounts receivable financing can be a
customer complicated process, but the basic idea is
- ensures the recording of the credit that companies can trade cash flows later
transaction clearly in the accounts of the for cash flows now, which is very useful for
business. companies that need cash right away. It
can also be expensive because factors
C. Tracking the payments received and assume the risk of collecting the
the payment that is due to be receivables, they are very choosy about
received which companies they work with and the
- this ensures correctness of accounting of creditworthiness of the companies'
the credit amount. The businesses shall customers.
also generate timely reminders for dues
pending to the customers Pledging or assignment of Account
Receivable
D. Accounting for the accounts the borrower simply pledges or assigns
receivable accounts receivable as a security for a
- must record all the due dates of the loan obtained from either a commercial
payments to be received. The timely and bank or a finance company. The
amount of the Loan is stated at a If the lender would provide billing and
percent of the face of the receivable collection services, the value of these
pledge. services would be considered as a
reduction of the cost of credit
If the receivable are pledge as a
collateral for the loan and the lender FACTORING ACCOUNTS RECEIVABLE
has no control over the quality of the involves the outright sale of the firm AR to
account receivable being pledged, the the finance company. The customer may be
loanable value is set a relative low instructed to remit the proceeds directly to
percent generally ranging downward the purchaser of the account. The factoring
from a maximum of around 75% firm generally does not have the recourse
against the seller of the AR.
EAR =
(AVE. RECEIVABLE % OF FV OF AR X In practice, the finance company may do
OVER PRIME RATE + AVE. PRIME RATE ) part or all of the credit analysis directly to
+ 1% X AVE. MONTHLY SALES X 12 insure the quality of the accounts. The
MONTHS)/ % OF FV OF AR AVE. AR X 1 factoring or finance company forwards
/360/360 funds immediately to the seller when the
account are accepted.
However, if the lender could select and
assess the credit worthiness of each Note:
individual accounts being pledge, the he factoring company not only absorbs
loan value might reach as high as 85 or the risk of non-collection but also
90% of the face amount. advances the funds to the seller a
month or so earlier than the seller
COST OF FINANCING would normally received them.
it is relatively high cost owing to the interest
rate charged on loan which is 2% to 5% COST OF FACTORING
higher than the bank’s prime rate and the For assuming the risk, the factoring firm
processing or handling fee of about 1 to 2% generally charges a fee or commission
on pledge accounts. ranging from 1 to 5% of the invoices
accepted. In addition, it charges interest on
Pledging of Receivable Illustration problem: funds advanced to the seller of the
accounts.
The KG sells plumbing supplies to building
contractors on terms net 60 day. The firms Example,
average monthly sales are 200,000, thus its if 200,000 a month processed at a 1%
average accounts receivable is 400,000, commission and 15% annual borrowing
based on the two months credit period. The rate is charged. The total effective cost is
company pledges all receivable to a local as follows:
BANK WHICH IN TURN ADVANCES UP TO
70% of the face value of the receivable at interest for one month (15/12) 1.25%
3% over prime rate and with a 1% commission 1.00%
processing fee on all receivable pledged. total monthly fee 2.25 %
Multiplied by: 12 months 12
The KG follows a practice of borrowing the annual rate 27%
maximum amount possible. The current
prime rate is 12% Variation: Should the firm wishes to
received immediate payment of its factored
Solution accounts
The Effective cost of this loan is as follows:
EAR = (400,000x70%x3%+12%) + 1% x
200,000X12 mos.)/70%x400,000 x
1/360/360
= 42,000+24,000/280,000x1/360/360
= 23.57
• If 200,000 in receivable is factored which
carry 30 day credit terms, a 1% factor fee,
6% reserve, an interest at 1% per month on
advances, then the proceed the firm can
received is as follows:
Face amount of the
receivable factored 200,000
Less: Fee (1% x 200,000) 2,000
Reserve (6% x 200,000) 12,000
Interest (1% x200,000) 2,000
Netproceeds 184,000
Effective Annual Financing Cost
2,000+2,000/184,000 x1/30/360
=26.09%
MARKETABLE SECURITIES
are securities or debts that are to be sold or
redeemed within a year.
Examples of Marketable Securities:
1. Government Bonds
2. Common Stock
3. Certificates of deposit
Notes:
Current Assets
If these securities and/or debt are
anticipated to be converted
into cash within one year, they are
listed at their current market
value, in the
Non Current Assets
If they are not trading securities
Held to maturity and available for sale,
securities can either be listed as long
term or short term, depending on the
maturity dates of the securities and the
intention of management regarding
conversion of these securities
should be a relatively small figure on
the balance sheet of most nonfinancial
companies.
Analysts use this information for
liquidity ratio analysis.
Creditors are interested in the
marketable securities figure in order to
understand what assets are liquid, in
case the company has solvency issues.
