FINANCIAL

REPORTING AND
ANALYSIS
Lecture: 15
Lecturer: HAROON IQBAL

OPERATING CYCLE
Efficiency

of operating cycle/process: It is
determined by activity ratios, keeping in view the
conversion process, which is as follows:Operating Cycle=Inventory sale days (average)
+Receivable Collection days (average).
The shorter the operating cycle, the higher the quality
of current assets and the greater the efficiency of
management.
Managing Accounts Receivable: The business
offers cash discount to encourage early payment or
factors Receivables i.e. selling Receivables to a
financial institution (factor).
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Cash Cycle
The length of time from the actual outlay of cash for

purchases until the collection of receivables resulting

from the sale of goods or services Current assets
(1) are in the form of cash,
(2) will be realized in cash, or
(3) conserve the use of cash

with in the operating cycle of a business or one year,

whichever is longer.
The five categories of assets usually found in current
assets, listed in their order of liquidity, include cash,
marketable securities, receivables, inventories, and
prepayments.
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The operating cycle for a company is the time period

between the acquisition of goods and the final cash

realization resulting from sales and subsequent
collections.
For example, a food store purchases inventory and
then sells the inventory for cash. The relatively short
time that the inventory remains an asset of the food
store represents a very short operating cycle.
In another example, a car manufacturer purchases
materials and then uses Labour and overhead to
convert these materials into a finished car. A dealer
buys the car on credit and then pays the
manufacturer. Compared to the food store, the car
manufacturer has a much longer operating cycle, but
it is still less than a year. Only a few businesses have
an operating cycle longer than a year.
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Cash is a medium of exchange that a bank will

accept for deposit and a creditor will accept for

payment. To be classified as a current asset, cash
must be free from any restrictions that would
prevent its deposit or use to pay creditors classified
as current. If restricted for specific-short term
creditors, many firms still classify this cash under
current assets, but they disclose the restrictions.
Cash restricted for short-term creditors should be
eliminated along with the related amount of shortterm debt when determining the short term debtpaying ability. Cash should be available to pay
general short-term creditors to be considered as
part of the firms short-term debt-paying ability.
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Marketable securities
The business entity has varying cash needs throughout

the year. Because an inferred cost arises from keeping

money available, management does not want to keep all
of the entitys cash need in the form of cash through the
year. The available alternative turns some of the cash
into productive use through short-term investments
(marketable securities) which can be converted into cash
as the need arises.
To qualify as a marketable security, the investment must
be readily marketable, and it must be the intent of
management to convert the investment to cash within
the operating cycle or one year, whichever is longer. The
key element of this test is managerial intent.
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It is to management advantage to show investments under

marketable securities, instead of long-term investments,

because
this
classification
improves
the
liquidity
appearance of the firm. When the same securities are
carried as marketable securities year after year, they are
likely held for a business purpose.
For example, the other company may be a major supplier
or customer of the firm being analyzed. The firm would not
want to sell these securities to pay short-term creditors.
Therefore, to be conservative, it is better to reclassify them
as investments for analysis purposes.
Investments classified as marketable securities should be
temporary. Examples of marketable securities include
treasury bills, short-term notes of corporations, government
bonds, corporate bonds, preferred stock, and common
stock. Investments in preferred stock and common stock
are referred to as marketable equity securities.
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Receivables
An entity usually has a number of claims to future inflows of

cash. These claims are usually classified as accounts

receivable and notes receivable on the financial statements.
the primary claim that that most entities have comes from the
selling of merchandise or services on account to customers,
referred to as trade receivables, with the customer promising
to pay within a limited period of time, such as 30 days.
The common characteristic of receivables is that the company
expects to receive cash some time in the future. This causes
two valuation problems.
First, a period of time must pass before the receivable can be

collected, so the entity incurs costs for the use of these funds.
Second collection may not be made.

Inventories
Inventor is often the most significant asset in determining the short-

term debt paying ability of an entity. Often the inventory account is

more than half of the total current assets. Because of the
significance of inventories, a special effort should be made to
analyze properly this important area.
To be classified as inventory, the asset should be for sale in the
ordinary course of business, or used or consumed in the production
of goods. A trading concern purchases merchandise in a form to sell
to customers. Inventories of a trading concern, whether wholesale
or retail, usually appear in one inventory account (merchandise
inventory). A manufacturing concern produces goods to be sold.
Inventories of a manufacturing concern are normally classified in
three distinct inventory accounts, inventory available to use in
production (raw materials), Inventory in production ( work in
process), and inventory completed (Finished goods)
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Determining Valuation and liquidity is a fairly

complicated
problem
when
analyzing
inventories. The basic approach to the
valuation of inventory uses cost. The cost
figure is often difficult to determine, especially
when dealing with manufacturing inventory.
because of the concept of conservatism, the
cost figure may not be acceptable if it can not
be recovered. Therefore if the market figure is
below cost the inventory is reduced to market.
Inventory is stated at lower of cost or market
on the financial statements

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