Efficiency of operating cycle, process

<< Analysis by Preferred Stockholders

STOCKHOLDERS’ EQUITY SECTION OF THE BALANCE SHEET 1 >>

Financial Statement Analysis-FIN621

Lesson-39

OPERATING CYCLE

Efficiency of operating cycle/process:

It is determined by activity ratios, keeping in view the

conversion process, which is as follows:-

Cash/assets ---- → Inventory ----→ Receivables ---- → Cash

Processing

Sales,

collection

Operating Cycle=Inventory sale days (average) +Receivable Collection days (average).

The shorter the operating cycle, the higher the quality of current assets and the greater the efficiency of

management.

Managing Accounts Receivable: The business offers cash discount (2/10, n/30) to

encourage early payment or "factors" Receivables i.e. selling Receivables to a financial institution

(factor).

Cash Cycle

The length of time from the actual outlay of cash for purchases until the collection of receivables

resulting from the sale of goods or services

Current assets (1) are in the form of cash, (2) will be realized in cash, or (3) conserve the use of cash

with in the operating cycle of a business or one year, whichever is longer.

The five categories of assets usually found in current assets, listed in their order of liquidity, include

cash, marketable securities, receivables, inventories, and prepayments.

The operating cycle for a company is the time period between the acquisition of goods and the final cash

realization resulting from sales and subsequent collections. For example, a food store purchases

inventory and then sells the inventory for cash. The relatively short time that the inventory remains an

asset of the food store represents a very short operating cycle. In another example, a car manufacturer

purchases materials and then uses Labour and overhead to convert these materials into a finished car. A

dealer buys the car on credit and then pays the manufacturer. Compared to the food store, the car

manufacturer has a much longer operating cycle, but it is still less than a year. Only a few businesses

have an operating cycle longer than a year.

Cash is a medium of exchange that a bank will accept for deposit and a creditor will accept for

payment. To be classified as a current asset, cash must be free from any restrictions that would prevent

its deposit or use to pay creditors classified as current. If restricted for specific-short term creditors,

many firms still classify this cash under current assets, but they disclose the restrictions. Cash restricted

for short-term creditors should be eliminated along with the related amount of short-term debt when

determining the short term debt-paying ability. Cash should be available to pay general short-term

creditors to be considered as part of the firm's short-term debt-paying ability.

Marketable securities

The business entity has varying cash needs throughout the year. Because an inferred cost arises from

keeping money available, management does not want to keep all of the entity's cash need s in the form

of cash through the year. The available alternative turns some of the cash into productive use through

short-term investments (marketable securities) which can be converted into cash as the need arises.

145

Financial Statement Analysis-FIN621

To qualify as a marketable security, the investment must be readily marketable, and it must be the intent

of management to convert the investment to cash within the operating cycle or one year, whichever is

longer. The key element of this test is managerial intent.

It is to management advantage to show investments under marketable securities, instead of long-term

investments, because this classification improves the liquidity appearance of the firm. When the same

securities are carried as marketable securities year after year, they are likely held for a business purpose.

For example, the other company may be a major supplier or customer of the firm being analyzed. The

firm would not want to sell these securities to pay short-term creditors. Therefore, to be conservative, it

is better to reclassify them as investments for analysis purposes.

Investments classified as marketable securities should be temporary. Examples of market able securities

include treasury bills, short-term notes of corporations, government bonds, corporate bonds, preferred

stock, and common stock. Investments in preferred stock and common stock are referred to as

marketable equity securities.

Receivables

An entity usually has a number of claims to future inflows of cash. These claims are usually classified

as accounts receivable and notes receivable on the financial statements. the primary claim that that most

entities have comes from the selling of merchandise or services on account to customers, referred to as

trade receivables, with the customer promising to pay within a limited period of time, such as 30 days.

The common characteristic of receivables is that the company expects to receive cash some time in the

future. This causes two valuation problems. First, a period of time must pass before the receivable can

be collected, so the entity incurs costs for the use of these funds. Second collection may not be made.

Inventories

Inventor is often the most significant asset in determining the short-term debt paying ability of an entity.

Often the inventory account is more than half of the total current assets. Because of the significance of

inventories, a special effort should be made to analyze properly this important area.

To be classified as inventory, the asset should be for sale in the ordinary course of business, or used or

consumed in the production of goods. A trading concern purchases merchandise in a form to sell to

customers. Inventories of a trading concern, whether wholesale or retail, usually appear in one inventory

account (merchandise inventory). A manufacturing concern produces goods to be sold. Inventories of a

manufacturing concern are normally classified in three distinct inventory accounts, inventory available

to use in production (raw materials), Inventory in production ( work in process), and inventory

completed (Finished goods)

Determining Valuation and liquidity is a fairly complicated problem when analyzing inventories. The

basic approach to the valuation of inventory uses cost. The cost figure is often difficult to determine,

especially when dealing with manufacturing inventory. because of the concept of conservatism, the cost

figure may not be acceptable if it can not be recovered. Therefore if the market figure is below cost the

inventory is reduced to market. Inventory is stated at lower of cost or market on the financial statements

Example No.1

Balance sheet of a business.

Assets

Liabilities & stockholders' equity.

Current Assets.

Current liabilities

(37%) 31,629,714

15,387,428

(18%)

146

Financial Statement Analysis-FIN621

(Includes subscription receivable

long-term liabilities

(12%)

Rs.7, 200,000

10,258,286

Fixed Assets

Stockholders' equity

59,840,000

(70%)

(63%)

53,856,000

Total:

85,485,714

Total

85,485,714

========

=======

147

Table of Contents: