Chapter 3 (A) -١

Financial Reports Analysis
Faculty of Commerce “English Section” – Level IV

- Course Code: ACC 401
Lecturer:
Dr. Mohamed Salem
Assistant Professor of
Accounting
Suez University
Teaching Assistant:
Dalia Mohamed
Class Policies
• Course Inquiries:
For any inquiries regarding lectures, tutorials, course materials
and appointments please do contact by mail:
muhammad.salem@com.suezuni.edu.eg
• Electronic Devices:
Laptops, tablets, or phones should only be used during class to
access the homework portal, review PowerPoint slides, or take
notes. Mobiles should be silenced before the class begin.
Course Syllabus
Ø Chapter (1): Introduction to Financial Reporting.
Ø Chapter (2): Basics of Analysis.
Ø Chapter (3): Liquidity of Short-Term Assets; Related
Debt Paying Ability.
Ø Chapter (4): Long-Term Debt Paying Ability.
Ø Chapter (5): Profitability.
Ø Chapter (6): Expanded Analysis.

Recommended Textbook
Gibson, C. H., Financial Statement Analysis. 12th
Edition. Cengage Learning, Education, Inc.
Chapter 3
Liquidity of Short-term
Assets and Related
Debt Paying Ability
Current Assets
• Current assets
– In the form of cash or will be realized in cash or conserve the use
of cash within the operating cycle, or one year, whichever is longer
• Typical examples
– Cash – Marketable securities
– Receivables – Inventories
– Prepayments
Operating Cycle
The time period between the acquisition of goods and the final
cash realization from sales.
Retail and Wholesale Manufacturing
Purchase inventory Purchase material

Cash sale to customer Produce finished
product
Sell to customer on
credit
Collect amount due
from customer
Current Assets: Cash
• Cash: a medium of exchange that a bank will accept for deposit

and a creditor will accept for payment.
• Unrestricted
– Available to pay creditors
– Report as current asset
• Restricted
– May report as current but disclose restrictions
– Eliminate cash and related current liability when measuring

short-term debt-paying ability
Current Assets: Cash (cont’d)
• Compensating balance
– A portion of loan proceeds required to be retained on
deposit.
– Increases effective interest rate
– Against current liability
Part of current assets; disclosure
– Against noncurrent liability
Reported as noncurrent asset

Current Assets: Marketable Securities
Debt and equity securities
Readily marketable
Managerial intent to convert to cash within the year or the

operating cycle, whichever is longer
Carried at fair value
• Analysis:
– Reclassify continuing investments as noncurrent

Current Assets: Receivables
• Claims to future cash inflows
• Arise from sales to customers
– Trade (account) receivables: claims received within a

short-term period, e.g., 30 days.
– Notes receivable
• Other current receivables

Current Assets: Receivables (cont’d)
• Valuation
– Ignore cost of fund use for delayed collection
– Assume rate of interest is reasonable
– Impairment
• Uncollectibility
• Allowed discounts
• Allowances given
• Returns
• Impairment: Accrue (allowance method)
– Based on estimate of receivables’ realizable value
– Set up allowance
• Expense recognized on income statement
• Asset reduced by contra account “Allowance”
– Expense on income statement before deducted on tax return
– Charge-off of a specific receivable

• Reduces accounts receivable and allowance for doubtful
accounts
• No impact on financial income or net assets
• Deductible event for income taxes
• Impairment: Direct write-off
– Alternative to accrual method when

• Receivables are not material or
• Amount for accrual cannot be reasonably estimated
– Charge-off of a specific receivable
• Recognize expense
• Reduce asset
– Bad debt expense likely to be recognized in a year

subsequent to the sale
• Does not match expense with revenue

• Trade receivables
– Typically collected within 30 days
• Installment receivables
– May be carried as a current asset yet collection may be

significantly longer than trade receivables
– Usually considered to be lower quality than trade receivables

• Customer concentration
– May impair the quality of receivables if a large portion of

receivables is from a few customers
• Liquidity
– Number of days’ sales in receivables
– Accounts receivable turnover

Days’ Sales in Receivables
Gross Receivables
æ Net Sales ö
ç ÷
è 365 ø
• Should mirror the company’s credit terms
• Reading reflects end-of-year status of receivables
– Use of the natural business year (lower sales at year-end)

can understate result
• Compare
– Firm data for several years
– Other industry firms and industry averages

Days’ Sales in Receivables (cont’d)
• Causes for overstatement
– Sales volume expands materially late in the year
– Receivables are uncollectible and should have been

written off
– The company seasonally dates invoices
– A large portion of receivables are on the installment

basis.
Days’ Sales in Receivables (cont’d)
• Causes for understatement
– Sales volume decreases materially late in the year
– A material amount of sales are on a cash basis
– The company has a factoring arrangement in which a

material amount of the receivables is sold to an outside
party
Accounts Receivable Turnover
Net Sales
Average Gross Receivables
• Indicates the liquidity of receivables
• Determining average gross receivables
– End of year and beginning of year base points for

average mask seasonal fluctuations
– Internal analysis: use monthly or weekly amounts
– External analysis: use quarterly data

Accounts Receivable Turnover in Days
Average Gross Receivables

æ Net Sales ö
ç ÷
è 365 ø
• Similar to Number of Days’ Sales in Receivables except

average receivables are used
• Should reflect firm’s credit and collection policies

Activity Task
Case
Required:
i. Compute the days’ sales in receivables for July 31,
2007, and December 31 2007.
ii. Compute the accounts receivable turnover for the
period ended July 31, 2007, and December 31, 2007.
iii. Comment on the results obtained from (i) and (ii)

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Financial Reports Analysis

Faculty of Commerce “English Section” – Level IV

Ø Chapter (1): Introduction to Financial Reporting.

Ø Chapter (2): Basics of Analysis.

Ø Chapter (3): Liquidity of Short-Term Assets; Related

Debt Paying Ability.

Ø Chapter (4): Long-Term Debt Paying Ability.

Ø Chapter (5): Profitability.

Ø Chapter (6): Expanded Analysis.

– Cash – Marketable securities

Purchase inventory Purchase material

• Cash: a medium of exchange that a bank will accept for deposit

– Report as current asset

– Eliminate cash and related current liability when measuring

– Increases effective interest rate

– Against current liability

Part of current assets; disclosure

– Against noncurrent liability

Reported as noncurrent asset

Debt and equity securities

Managerial intent to convert to cash within the year or the

Carried at fair value

– Reclassify continuing investments as noncurrent

• Claims to future cash inflows

• Arise from sales to customers

– Trade (account) receivables: claims received within a

• Other current receivables

– Assume rate of interest is reasonable

– Based on estimate of receivables’ realizable value

• Expense recognized on income statement

• Asset reduced by contra account “Allowance”

– Expense on income statement before deducted on tax return

– Charge-off of a specific receivable

– Alternative to accrual method when

– Bad debt expense likely to be recognized in a year

• Does not match expense with revenue

– Typically collected within 30 days

– May be carried as a current asset yet collection may be

– Usually considered to be lower quality than trade receivables

– May impair the quality of receivables if a large portion of

– Number of days’ sales in receivables

– Accounts receivable turnover

• Reading reflects end-of-year status of receivables

– Use of the natural business year (lower sales at year-end)

– Firm data for several years

– Other industry firms and industry averages

• Causes for overstatement

– Sales volume expands materially late in the year

– Receivables are uncollectible and should have been

– The company seasonally dates invoices

– A large portion of receivables are on the installment

• Causes for understatement

– Sales volume decreases materially late in the year

– A material amount of sales are on a cash basis

– The company has a factoring arrangement in which a

• Indicates the liquidity of receivables

• Determining average gross receivables

– End of year and beginning of year base points for

– Internal analysis: use monthly or weekly amounts