BBMF3063 Financial Statement Analysis

Tutorial 4 – Analyzing Investing Activities

1. a. Identify the main concerns in analysis of accounts receivable.

Analysis must be alert to changes in the allowance – computed relative to sales,

receivables or industry and market conditions

Two special analysis questions: COLLECTION RISK

i. Review allowance for uncollectibles in light of industry conditions
ii. Apply special tools for analyzing collectability:
a. Determining competitors receivables as a percent of sales
b. Examining customer concentration – risk increases when receivables are
concentrated in one or a few customers
c. Investigating the age pattern of receivables – overdue and for how long
d. Determining portion of receivables that is a renewal of prior receivables
e. Analyzing adequacy of allowances for discounts, returns and other credits

The main concerns in analysis of accounts receivable are:

1. Is the receivable genuine, due and enforceable?
2. Has the probability of collection been properly assessed?

Some receivables may not be genuine because of return policy

 every time you make sales, it’s considered accounts receivable but there is a return
policy, they are allowed to return it within 2 weeks -> they are not genuine accounts
receivable
 Must also have allowance for bad debts, maybe 10%
 Due – whether the credit period has expired, can only collect when it is due
 Enforceable, can the customer actually pay you? They could be in financial distress

b. Describe information, other than that usually available in financial statements, that we
should collect to assess the risk of non collectibility of receivables.

Apply special tools for analyzing collectability:

a. Determining competitors receivables as a percent of sales
b. Examining customer concentration – risk increases when receivables are
concentrated in one or a few customers
c. Investigating the age pattern of receivables – overdue and for how long
d. Determining portion of receivables that is a renewal of prior receivables
e. Analyzing adequacy of allowances for discounts, returns and other credits
The information that used by management to estimate the allowance for uncollectibles based
on experience, customer fortunes, economy and industry expectations, and collection policies.

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Information that would be helpful in assessing the general level of collection risks with
receivables is not usually found in published financial statements. Such information can, of
course, be sought from the company directly. Examples of such information are:
 What is customer concentration? [Concentration risk = accounts receivable
made of only 3 customers, ie Customer A 70%, Customer B 20%, C 10%, if
customer A defaults, 70% of accounts receivable cannot be collected]
 What percent of total receivables is due from one or a few major customers?
 Aging patterns [<1 mnth = 10,000; 1-3mnth = 20,000; about 3 mnth = 70,000;
you will know that most of them owe you for more than 3 months]
 Repeated debtors
Jan Feb Mar Apr
A D F J
B A G A
C E A K
You notice that A is always your debtor for each month (repeated
debtor)
 Would failure of any one customer have a material impact of the company’s
financial condition?
 EXPERIENCE: Follow industry practice – if there is history of 50% becoming
uncollectible, must allow for 50% bad debts
 COLLECTION POLICY: Set of procedures a company uses to ensure payment
of accounts receivables. It is similar to the credit policy as it should be written
and strictly followed.

2. Compare and contrast the effects of LIFO and FIFO inventory costing methods on earnings in
an inflationary period. Provide Illustration.

In an inflationary period (rising prices or increasing inventory quantities), the impact of LIFO and
FIFO on financial statements are as follows:
LIFO FIFO
COGS Higher Lower
Net Income Lower Higher
*Cash Flow Higher Lower
Inventory Balance Lower Higher
Working Capital Lower Higher

In an inflationary period:
i. COGS
- LIFO higher because cost of goods sold is cheaper
- FIFO lower because cost of goods sold is more expensive
ii. Net Income

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- LIFO lower because of higher cost of goods sold

- FIFO higher because of lower cost of goods sold
iii. Cash Flow
- LIFO higher because lower gross profit, less tax, more cash flow
- FIFO lower because higher gross profit, more tax, less cash flow
iv. Inventory balance
- LIFO lower (because based on unsold amount)
- FIFO higher
v. Working capital
- LIFO lower
- FIFO higher

3. Cost for inventory purposes should be determined by the inventory cost flow method best
reflecting periodic income.

Required:
a. Describe the inventory cost flow assumptions of (1) average-cost, (2) FIFO, and (3) LIFO.

Average-cost – when a unit is sold, the average cost of each unit in inventory is assigned
to cost of goods sold (Cost of goods available for sale / Units available on the date of
sale)

FIFO:
- Oldest costs -> costs of goods sold
- Recent cost -> ending inventory

LIFO
- Recent costs -> costs of goods sold
- Oldest costs -> ending inventory

b. Discuss management’s usual reasons for using LIFO in an inflationary economy.

- Using LIFO will incur less tax

- COGS is more accurate using LIFO as costs assigned to good sold is of recent
costs

Use of LIFO method of tax accounting for inventories is beneficial in an inflationary

economy because it permits a taxpayer to compute a higher cost of goods sold
deduction by using inflated current cost rather than a lower cost of goods sold
deduction based on the lower historic cost. LIFO reports lower profits therefore less
tax is paid resulting in higher cash flow.

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[During inflation, price levels go up & purchasing power is reduced -> 1 dollar you
can buy less during inflationary period.
First, company prefers to use LIFO because it gives a better reflection of goods sold
(using latest price), better reflection of revenue vs cost.
Second, it gives you lower profit, pay less tax. Company has more cash to use, better
cash now than cash in future. Can buy more things-> higher purchasing power.

c. When there is evidence the value of inventory, through its disposal in the ordinary course
of business is less than cost, what is the accounting treatment? What concept justifies this
treatment?

Inventory < cost

Must write down inventory to the amount that can be realized under concept of
conservatism.

When there is evidence that the utility of goods, in their disposal during the ordinary course of
business, will be less than cost, the proper accounting treatment would be the LCM (lower of
cost or market) methodology. It will be treated as a loss. The concept under which this
treatment is justified is conservatism. “Conservatism holds that when you are in doubt, it is best
to choose the accounting alternative that will be least likely to overstate assets or income.” The
usage of the LCM accounting treatment demonstrates the concept of conservatism in that,
“when the cost of inventory exceeds its expected benefit, a reduction of the inventory to its
market value is a better measure of its expected future benefit”.
“CONSERVATISM: RECOGNIZE LOSS IMMEDIATELY – expense in P&L , POSTPONE GAINS”

Why would they sell at lower than cost price? TWO POSSIBLE REASONS
i. Inventory becomes obsolete – no longer in demand, if you want to clear the stock,
must sell lower than the cost (usually in electrical appliances or tech)
ii. Damaged goods – when there is flooding etc, if you sell washing machine & the
warehouse was flooded up to 1 feet, the washing machine is not truly affected ->
dirtied but it is still usable -> still considered damaged goods

If TV is worth B/V 1,000, but you sell it at 800. Must change the Book Value to 800. The 200
must be treated as a loss and must be expensed off.

4. Droog Co. is a retailer dealing in a single product. Beginning inventory at January 1 of this
year is zero and operating expenses for this same year are $5,000. The following
purchases are made this year: (IMPORTANT)

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Ending inventory at December 31 is 800 units. End-of-year assets, excluding inventories,

amount to $75,000, of which $50,000 of the $75,000 are current. Current liabilities amount to
$25,000, and long-term liabilities equal $10,000.

Required:

a. Determine net income for this year under each of the following inventory methods. Assume a
sales price of $25 per unit and ignore income taxes.
(1) FIFO

Inventory on January 1 0 units

Purchased on Jan 100 units @ $10 1,000
March 300 units @ $11 3,300
June 600 units @ $12 7,200
October 300 units @ $14 4,200
December 500 units @ $15 7,500
Remaining 800 units

FIFO:
COGS = 1,000 + 3,300 + 7,200
= 11,500
Assuming sales price of $25 per unit:
Amount sold = Total – 800
= 1,000
Revenue = (25 x1,000)
= 25,000

Gross income = 25,000 – 11,500

= 13,500

Net Income = 13,500 – 5,000 = 8,500

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(2) LIFO
COGS = 7,500 +4,200+(200/600 *7,200)
= 14,100

Gross Income = 25,000 – 14,100

= 10,900

Net Income = 10,900 – 5,000 = 5,900

(3) Average cost

Average cost per item
= 23,200/1800
= 12.89

COGS = 1,000 x 12.89

= 12,888.89

Gross Income = 25,000 – 12,888.89

= 12,111.11

Net Income = 12,111.11-5,000 = 7,111.11

b. Compute the following ratios under each of the inventory methods of FIFO, LIFO, and
average cost.
(1) Current ratio

FIFO:
CA/CL = [50,000 + (23,200 – 11,500)] / 25,000
= 61,700 / 25,000
= 2.468

LIFO:
CA/CL = [50,000 + (23,200 – 14,100)] / 25,000
= 59,100 / 25,000
= 2.364

Average:
CA/CL = [50,000 + (23,200 – 12,888.89)] / 25,000
= 60,311.11 / 25,000
= 2.412

(2) Inventory turnover

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FIFO:
Cost of sales/Average inventory
= 11,500/11,700
= 0.9829

LIFO:
Cost of sales/Average inventory
= 14,100 / 9,100
= 1.5495

Average:
= Cost of sales/Average inventory
= 12,888.89 / 10,311.11
= 1.2500

(3) Gross margin as a percent of sales (Sales – Cost of sales) / Sales x 100

FIFO:
(25,000 – 11,500)/25,000 x 100
= 54%

LIFO:
(25,000 – 14,100)/25,000 x 100
= 43.6%

Average:
(25,000 – 12,888.89) / 25,000 x 100
= 48.44%

(4) Net profit as a percent of sales (Net Income / Sales) x 100

FIFO: (25,000 – 11,500 - 5,000) / 25,000 x 100

= 8,500/25,000 x100
= 34%

LIFO: (25,000 – 14,100 – 5,000) / 25,000 x 100

=5,900 / 25,000 x 100
= 23.6%

Average: (25,000 – 12,888.89 – 5,000) / 25,000 x 100

= 7,111.11/25,000 x 100
= 28.44%

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(5) Debt to equity ratio = Liabilities / Equity (WRONG ANS)

Current equity =A–L

= 75,000 – 35,000
= 40,000

FIFO: Total equity = 40,000 + net profit 8,500

= 48,500
D/E ratio = 35,000/48,500
=0.7216

LIFO: Total equity = 40,000 + net profit 5,900

= 45,900
D/E ratio = 35,000/45,900
= 0.7625

Average: Total equity = 40,000 + net profit 7,111.11

= 47,111.11
D/E ratio = 35,000/47,111.11
= 0.7429

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c. Discuss the effects of inventory accounting methods for financial statement analysis given the
results from parts a. and b.

It will affect COGS, Net Income, Cash Flow, Inventory balance and working capital.
Using different inventory accounting methods can greatly affect the financial statement analysis
and inflate the numbers and may give an inaccurate picture of the financial position of the
company.

(Should be similar ans with Q2/3)