Chapter 5 - Financial Position

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Management and Organizational Studies
Management and Organizational Studies 3360A/B
Michelle Loveland

Usefulness of the Statements of Financial Position and Cash Flows from a Business Perspective Analyzing a Statement of Financial Position Provides information about a company's liquidity and solvency in order to assess the risk of investing in a company. Provides details about the company's financial structure, such as whether it is financed primarily by debt or equity. Assessing Earnings Quality One concern of users of financial statements is that company insiders might manipulate information to make earnings look better or worse than they are, for strategic reasons. Assessing the Credit Worthiness of Companies Creditors often rely on the statement of financial position to assess a company's liquidity and its ability to service debt. Statement of Financial Position Statement of financial position (Balance sheet): reports a business enterprise's assets, liabilities, and shareholders' equity at a specific date. it helps in predicting the amounts, timing, and uncertainty of future cash flows. Usefulness of the Statement of Financial Position The SFP is useful for analyzing a company's liquidity, solvency, and financial flexibility. Helps with analyzing the profitability, but not primary focus…) Liquidity: Depends on the amount of time that is expected to pass until an asset is realized. (converted into cash or other monetary asset). Current Ratio Quick Ratio Acid Test Current cash debt coverage ratio The liquidity of certain assets, like receivables and inventory, is assessed through turnover ratios. Creditors are interested in short-term liquidity ratios. In general, the greater the liquidity, the lower the risk of enterprise or business failure. Solvency: Reflects an enterprise's ability to pay its debts and related interest. Coverage ratios… Liquidity and solvency affect an entity's financial flexibility: 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. Limitations of the Statement of Financial Position 1. Many assets and liabilities are stated at their historical cost. 2. Judgements and estimates are used in determining many of the items reported in the SFP. Includes many "soft" numbers. 3. The SFP necessarily leaves out many items that are of relevance to the business but cannot be recorded objectively. Classification in the Statement of Financial Position SFP accounts are classified so that similar items are grouped together to arrive at significant subtotals. Helps analysts and other financial statement users by grouping items with similar characteristics and separating items with different characteristics. 1. Assets that are of a different type or that have a different function in the company's activities should be reported as separate items. 2. Liabilities with different implications for the enterprises's financial flexibility should be reported as separate items. 3. Assets and liabilities with different general liquidity characteristics should be reported as separate items. 4. Certain assets, liabilities, and equity instruments have attributes that allow them to be measured or valued more easily. Monetary versus Nonmonetary Assets and Liabilities Monetary assets represent either money itself or claims to future cash flows that are fixed and determinable in amounts and timing. Likewise, liabilities that require future cash outflows that are fixed and determinable in amounts and timing. Nonmonetary assets - their value in terms of a monetary unit such as dollars is not fixed. Financial Instruments Financial Instruments are contracts between two or mote parties that create financial assets for n party and financial liability or equity instrument for the other. They are often marketable or tradable, and therefore easy to measure. Many financial instruments are also monetary assets or liabilities. Examples: Cash Contractual rights to receive cash or another financial instrument Equity investments in other companies. Contractual rights to receive cash or other financial instruments are assets, whereas contractual obligations to pay are liabilities. Elements of the statement of financial position 1. Assets: Present economic benefits that are controlled by an entity as a result of past transactions or events. 2. Liabilities: Present obligations that arise from past transactions or events. 3. Equity/Net assets: The residual interest in an entity's assets that remains after deducting its liabilities. In a business enterprise, the equity is the ownership interest. Preparation of the Classified Statement of Financial Position (Balance Sheet) Current Assets: Current assets: include cash and other assets that will ordinarily be realized within one year from the date of the statement of financial position or within the normal operating cycle if the cycle is longer than a year. Current assets are generally segregated and presented in the SFP in order according to their liquidity. Major items: 1. Cash: at its stated value Cash is often grouped with other cash-like liquid assets and reported as Cash and cash equivalents. Cash: defined as cash, demand deposits, and short-term, highly liquid investments that are readily convertible into known amounts of cash and have an insignificant risk of changing in value. 2. Investments: at cost/amortized cost or fair value Companies that have excess cash often have significant amounts of short-term investments. 3. Accounts receivable: at the estimated amount that is collectible. Should be segregated to show ordinary trade accounts, amounts owing by related parties, and other unusual items of a substantial amount. Anticipated losses due to uncollectibles should be accrued. The amount and nature of any non trade receivables and any receivables that have been designated or pledged as collateral should be disclosed. 4. Inventories: generally at the lower of cost and net realizable value Inventories are assets: 1. Held for sale in the ordinary course of business 2. In the process of production for such sale, or 3. In the form of materials or supplies to be consumed in the production process or in the rendering of service. Determined using a cost formula: First in, first out (FIFO) Weighted average cost Specific identification 5. Prepaid items: at cost Prepaid expenses included in current assets are expenditures already made for benefits (usually services) that will be received within one year or the operating cycle, whichever is longer. Non-Current Investments See Illustration 5 - 7 page 232 for types of accounts... Long term investments are usually presented on the SFP just below current assets in a separate section called "Investments". Property, Plant, and Equipment
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