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BACKGROUND
Balance sheet- financial statement show a firm’s accounting value on a particular date. * Assets are classified as current or fixed. Fixed assets have a relatively long life. Fixed assets can also be tangible (eg. Truck or computer) or intangible (e.g. trademark or patent) * Liabilities are classified as current if they have life of less than 1 year. Otherwise , they are considered to be long term. Often refers to bonds. * Stockholders equity = Assets – liabilities , reflects the fact if the firm were to sell all its assets, used the money to pay its debts, then whatever residual value remained would belong to shareholders.
Net working capital – current assets – current liabilities. It is usually positive in a healthy firm.
There 3 things to consider in a balance sheet: liquidity, debt versus equity, and market value versus book value. Debt can be used as a financial leverage in the sense it can greatly magnify both gains and losses.
Concepts Review and Critical Thinking Questions: 1,2,3,5
1. [Liquidity] What does liquidity measure? Explain the tradeoff a firm faces between high liquidity and low liquidity levels. Liquidity refers to the speed and ease with an asset can be converted to cash and it bas 2 dimensions: ease of conversion vs loss of value. e. It’s desirable for firms to have high liquidity so that they have a large factor of safety in meeting short-term creditor demands. However, since liquidity also has an opportunity cost associated with it—namely that higher returns can generally be found by investing the cash into productive assets—low liquidity levels are also desirable to the firm. It’s up to the firm’s financial management staff to find a reasonable compromise between these opposing needs.
2. [Accounting and Cash Flows] Why might the revenue and cost figures shown on a standard income statement not be representative of the actual cash inflows and outflows that occurred during a period? The income statement equation is revenue-expenses = income. In practice, for the income statement revenue is recognized at the time of sale, which need not be the same as the time of collection. Expenses are then recorded based on the matching principle, the basic idea is to match revenues with the costs associated with producing them. In other words, if we manufacture a product and then sell it on credit, the revenue is realized at the time of sale. The production and other costs associated with the sale of the product will likewise be recognized at that time. Once again actual cash flows may occur at some different time.
Also for noncash items, such as long terms assets , the concept of depreciation cost is an accounting way of applying the matching principle. The
