Question 2.2 – Accounting and Cash Flows: Why is it that the revenue and cost figures shown on a standard income statement may not be representative of the actual cash inflows and outflows that occurred during a period? Financial Statements are prepared according to accrual rule of , according to which cost and revenue are recorded as they occur and not when they are actually received or paid. This is why cash flows during the year may be different from revenue and costs in income statements. Different companies use different policies to pay the costs and collect revenues in current and subsequent years. In other words, the income statement assumes that once a good is sold, it is also paid for at that exact same time. Typically collection of revenue does not happen at the same time of delivery.
As I reflect on managerial accounting, I recall that some companies only collect twenty-five percent the same month of the sale. Then, they collect the other fifty percent the month after and the final twenty-five percent two months after the sale. Question 2. 3 – Book Values versus Market Values: In preparing a balance sheet, why do you think standard accounting practice focuses on historical cost rather than market value? When comparing book value to market value it is simply what the firm paid for the item versus what the firm could sell the items on the market.
Book values are used because they have a historical perspective associated with them. I understand from my readings that the book values are the “minimum” or worst case scenarios of what these items are worth. Question 2. 4 – Operating Cash Flow: In comparing accounting net income and operation cash flow, what two items do you find in net income that are not in operating cash flow? Explain what each is and why it is excluded in operating cash flow. Operating cash flow is revenues minus the costs, except for depreciation and financing interest, because neither of these is paid in cash.
Cash flows are important because the cash flow reflects, basically, whether a company’s outflows of cash can meet their inflows of cash. Net income does include financing interest and depreciation, because all liabilities need to be accounted for. Question 3. 4 – Financial Ratios: Fully explain the kind of information the following financial ratios provide about the firm. Many companies use financial ratios to avoid problems with comparing companies of different sizes.
A “quick ratio” is also known as “acid-test” and is an indicator of a company’s short-term liquidity. Furthermore, the quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets. The higher the quick ratio’s the better the position of the company. A quick ratio is calculated as follows: Quick Ratio = Current Assets – Inventory – Inventories / Current Liabilities As notes in our text, the using cash to buy inventory does not affect the current ratio, but it reduces the quick ratio.
The idea is that inventory is relatively illiquid compared to cash. (Ross, Westerfield, Jordan, p. 57) A “cash ratio” equals cash divided by current liabilities. The ratio of a company’s total cash and cash equals it’s current liabilities. The cash ratio is most commonly used as a measure of company liquidity. It can determine if, and/or how quickly the company can repay its short-term debt. A strong cash ratio is useful to creditors when deciding how much debt, if any, they would be willing to extend to the asking party. (Investopedia. om) Furthermore, the cash ratio is generally a more conservative look at a company’s ability to cover its liabilities than many other liquidity ratios. Mainly, due to the fact that inventory and accounts receivable are left out of the equation. Since these two accounts are a large part of many companies, this ratio should not be used in determining company value, but simply as one factor in determining liquidity. Finally, the “capital intensity ratio” is a ratio measures the ability of a company to effectively use its assets.
Simply put, capital intensity shows how much of an investment in fixed assets was required during a given period to produce $1 of sales revenue. The actual ratio formula to measure capital intensity is total assets divided by sales revenue for a specified period. One of the major problems with ratios is that different organizations and different sources often don’t compute them exactly the same way, which lead to confusion and false results. The definitions are vague and when comparing to other’s equations, you may find significant results depending on the way they are computed.