Chapter 5 - Balance Sheet & Statement of Cash Flows Flashcards
Why is the Balance Sheet useful?
By reporting information on assets, liabilities, and stockholders’ equity, the balance sheet provides a basis for computing rates of return and evaluating the capital structure of the enterprise.
Also use information in BS to assess a company’s risk and future cash flows.
Assess a company’s liquidity, solvency, and financial flexibility.
When using the Balance Sheet to analyze a company, what is a company’s liquidity?
The amount of time that is expected to elapse until an asset is realized or otherwise converted into cash or until a liability has to be paid.
Creditors use ratio to indicate whether a company will have the resources to pay its current and maturing obligations.
Stockholders assess liquidity to evaluate the possibility of future cash dividends or the buyback of shares.
The greater a company’s liquidity, the lower its risk of failure.
When using the Balance Sheet to analyze a company, what is a company’s solvency?
The ability of a company to pay its debts as they mature.
When a company carries a high level of long-term debt relative to assets, it has lower solvency than a similar company with a low level of long-term debt.
Companies with higher debt are relatively more risky because they will need more of their assets to meet their fixed obligations (interest and principal payments).
Companies group investments in debt securities into three separate portfolios for valuation and reporting purposes. Identify and define those three portfolios.
Held-to-Maturity: Debt securities that a company has the positive intent and ability to hold to maturity.
Trading: Debt securities bought and held primarily for sale in the near term to generate income on short-term price differences.
Available-for-Sale: Debt securities not classified as held-to-maturity or trading securities.
When using the Balance Sheet to analyze a company, what is a company’s financial flexibility?
Liquidity and solvency affect a company’s financial flexibility, which measures the ability of an enterprise to take effective actions to alter the amounts and timing of cash flows so it can respond to unexpected needs and opportunities.
A company with a high degree of financial flexibility is better able to survive bad times, to recover from unexpected setback, and to take advantage of profitable and unexpected investment opportunities.
What are some of the major limitations of the balance sheet? (3)
- Most assets and liabilities are reported at historical cost.
- Companies use judgments and estimates to determine many of the items reported in the balance sheet.
ex. estimate the amount of AR that it will collect,
the useful life of equipment, warranty returns - BS necessarily omits many items that are of financial value but that a company cannot record objectively.
ex. value of knowledgeable/skilled employees,
reputation, research superiority
What is Working Capital?
The excess of total current assets over total current liabilities. Represents the net amount of a company’s relatively liquid resources. The Liquidity buffer available to meet the financial demands of the operating cycle.
What is the adjusting journal entry after a physical count of inventory on hand?
Debit to COGS
Credit to Inventory
Why does the FASB require companies to provide a Statement of Cash Flows?
None of the other financial statements presents a detailed summary of all the cash in flows and out flows, or the sources and uses of cash during the period.
What does the Statement of Cash Flows report? (4)
- the cash effects of operations during a period
- investing transactions
- financing transactions
- the net increase or decrease in cash during the period
What ratio is used to assess Financial Liquidity?
Current Cash Debt Coverage = Net Cash Provided by Operating Activities / Average Current Liabilities
This indicates whether the company can pay off its current liabilities from its operations in a given year.
The higer the current cash debt coverage, the less likely a company will have liquidity problems. For example, a ratio near 1:1 is good. It indicates that the company can meet all of its current obligations from internally generated cash flow.
What ratio is used to assess Financial Flexibility?
Cash Debt Coverage = Net Cash Provided by Operating Activities / Average Total Liabilities
This indicates a company’s ability to repay its liabilities from net cash provided by operating activities, without having to liquidate the assets employed in its operation.
The higher the ratio, the less likely the company will experience difficulty in meeting its obligations as they come due. It signals whether the company can pay its debts and survive if external sources of funds become limited or too expensive.
What is the “direct method” of presenting cash flow from operations?
This method directly shows the amount of cash inflows and outflows from operations. It shows cash received from sales and cash paid in operations.
What is the “indirect method” of presenting cash flow from operations?
This method is a reconciliation of the accrual-based net income to derive cash flows from operations.
