Accounting Notes

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Class 7 – Current Assets

• Current assets are those assets that can be converted in to cash (or whose future benefit we will recognize) within one year or within the next business cycle.
• They are principally comprised of:

• Cash (more on cash in classes 9 and 10)
• Marketable Securities (more on investments in class 17)
• Accounts Receivable (we discussed this asset in Class 5 and 6)
• Inventory (today’s focus)
• Prepaid Expenses (today’s focus)

Balance Sheet Geography

• Current assets are typically lined up as below:

• Cash
• Marketable Securities
• Accounts Receivable
• Inventory
• Prepaid Expenses

• Why might current assets be lined up as they are on the left hand side?
• A.) The most predictive assets are first
• B.) The most relevant assets come first
• C.) The largest assets come first
• D.) The assets that are easiest to convert in to cash come first
• Assets are listed in order of liquidity
• This is true whether they are current or long term

The Curious Case of FCUK

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What’s novel about FCUK’s balance sheet?

It appears to be structured in terms of reverse liquidity

It is structured as A – L = E instead of A = L + E

Where is cash?

Buried about mid-way through

Why are they doing this?

They wanted to focus on core assets at the top? Probably not these assets aren’t very big.

They’re a trend setting fashion company and this is also reflected in their balance sheet?

Something else?

Another conceptual framework issue: Comparability

Does FCUK facilitate comparability with its peers by setting up their financials this way?

Measures of Short-Term Risk

• Working Capital = Current Assets – Current Liabilities
• Would we prefer a positive or negative amount of working capital? A.) Positive B.) Negative

Ratio #2: Current Ratio

• Current assets / Current liabilities
• Measure of ability of the firm to pay short-term liabilities on time

Ratio #3: Quick Ratio

• Current highly liquid assets / Current liabilities
• Current highly liquid assets (i.e., cash, marketable securities, accounts receivable) – no inventory or prepaid expenses

• For either ratio you want a value over 1.
• i-Clicker : Which firm might have current and quick ratios that differ dramatically?
• A.) A Big 4 Auditing firm B.) FCUK C.) An airline D.) Dell

Ratio #4: Inventory Turnover

• Inventory Turnover = COGS / Average Inventory
• Days Inventory = (Average Inventory / COGS)X 365
• Indicates how fast firms sell merchandise.
• If inventory turn over twice a year, then they average one-half of a year in inventory (and a days inventory of 182.5)
• Why do we typically want a higher inventory turnover?
• Because holding inventory is costly

Danier Leather

• From the assets listed below, which do you think was Danier Leather’s biggest asset on June 30, 2012?
• A. ) Intangible Assets B.) Accounts Receivable C.) Prepaid Expenses D.) Inventories  E.) Property, Plant and Equipment

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重点： inventory包含什么

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Is increase in days of inventory always a good thing? No.

• Should cost of goods sold for the year be affected much by the month of the fiscal year end, for a firm like Danier that doesn’t appear to be growing?
• A.) Yes B.) No
• Should inventories on the balance sheet be affected by the month of the fiscal year end?
• A.) Yes B.) No
• The Company’s business is seasonal with peak working capital needs expected to occur during the period from June to mid-December as inventory levels are increased in advance of the anticipated peak selling season.
• What would days inventory look like if the year end was November 2012 instead of June 2012? A.) higher B.) lower
• Higher!
• If you wanted to minimize your days inventory and you were a clothes retailer, which month should you choose for a year end? A.) Jan B.) October C.) September D.) November E.) August (inventory 最少的时候)
• January seems like a good choice. Let’s look at FCUK.

Danier Leather – Obsolescence

• Merchandise inventories (finished goods) at Danier are valued at the lower of cost or net realizable value (i.e.., market value).
• Do you think Danier will have a material amount of obsolescence?
• What is the lower of cost or market value application consistent with? A.) relevance B.) historical cost C.) comparability D.) conservatism E.) A & D
• D.) Let’s look at the journal entry

Dr. Write-down of inventory

        Cr. Inventory

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Magnotta Wines

• Let’s talk a bit about the business model (e.g. product/customers)?
• Without looking at the balance sheet. What sorts of assets should a wine maker have?
• For each asset we bring up, where do you think it should be found on the balance sheet/
• A.)  Property Plant and Equipment B.) Inventory – Raw materials C.) Inventory –WIP D.) Inventory – Finished Goods

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• Should we be concerned with the number of days product stays in inventory?
• Maybe. Note, the aging process can take years. A lot of this is W-I-P. A long days inventory is a function of their business model (all wineries have the same issue)
• From the financials, can we make a rough estimate of how long it takes to ferment a bottle of Magnotta’s Vidal Ice Wine?
• ~1.2 years or 440 days by looking at the days spent in work-in-process inventory.
• ***An important point. Ratio analysis tells you something in isolation, but tells you even more if you can benchmark it against something else (like for example industry averages or the firm over time).

• Building on the latter point, assess the following companies. Which should have a longer days inventory than Magnotta?
• A.) Loblaws B.) Space Shuttle Manufacturer C.) Toys ‘R Us D.) McKinsey E.) GM
• McKinsey – service based organization no inventory
• Loblaws – retailer with perishable product
• Toys ‘R Us – retailer with non-perishable products
• GM – manufacturer and retailer with non-perishables
• Magnotta – manufacturer, long W-I-P, retailer
• Space Shuttle Manufacturer – 5 years minimum to build one. So inventory sits in W-I-P for a looong time.
• Takeaway: ratios can be good or bad depending on the industry norms!

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• Do the two liquidity measures paint similar or opposing pictures about the firms ability to meet short term obligations (i.e., liquidity)? A.) similar B.) opposing
• Very much opposing
• Which balance sheet item accounts for the difference between the ratios?
• A.) cash B.) accounts receivable C.) inventory D.) bank indebtedness
• If Magnotta needed to pay off its short term creditors immediately, would it be easy to quickly sell of its inventory? A.) Yes B.) No
• Grapes – perhaps they could sell them off to another company, but its not clear that there is a market as each wine maker’s specific type of grape
• aging wine – There is a limited market here
• E.g., It’s not clear that Inniskillen wines who make their own ice wine would want Magnotta ice wines
• Finished goods – They sell product predominantly through their own stores. Is it easy to push product through your own stores?

• What’s Magnotta’s biggest current liability?
• Bank Indebtedness
• What do we know about this liability?
• It’s a line of credit at the bank that the bank can recall at any time!!
• Combine all of your inferences, what might be the biggest threat to the firm’s business?
• Current assets are tied up in inventory that may be hard to get rid of
• The firm has no cash on the balance sheet
• The biggest current liability might be due at any time.
• Magnotta may have a lot of short term liquidity risk!

Prepaid Expenses

• A prepaid expense – services that the firm has paid for before consuming them – rent, insurance, or advertising.
• Journal entry when the prepayment first happens:

Dr. Prepaid expense

                Cr. Cash