Current assets cash and cash equivalents

ADS

Current assets include cash and other assets that are convertible to cash, usually within the operating cycle of the company. An operating cycle, shown in Exhibit 4.1, is the amount of time from commitment of cash for purchases until the collection of cash resulting from sales of goods or services. It is the process by which a company converts cash into short-term assets and back into cash as part of its ongoing operating activities. For a manufacturing company, this would entail purchasing raw materials, converting them to finished goods, and then selling and collecting cash from receivables. Cash represents the starting point, and the end point, of the operating cycle. The operating cycle is used to classify assets (and liabilities) as either current or noncurrent. Current assets are expected to be sold, collected, or used within one year or the operating cycle, whichever is longer.1 Typical examples are cash, cash equivalents, short-term receivables, short-term securities, inventories, and prepaid expenses. 

The excess of current assets over current liabilities is called working capital. Working capital is a double-edged sword companies need working capital to effectively operate, yet working capital is costly because it must be financed and can entail other operating costs, such as credit losses on accounts receivable and storage and logistics

costs for inventories. Many companies attempt to improve profitability and cash flow by reducing investment in current assets through methods such as effective credit underwriting and collection of receivables, and just-in-time inventory management. In addition, companies try to finance a large portion of their current assets through current liabilities, such as accounts payable and accruals, in an attempt to reduce working capital. Because of the impact of current assets (and current liabilities) on liquidity and profitability, analysis of current assets (and current liabilities) is very important in both  credit analysis and profitability analysis. We shall discuss these issues at length later in the book. In this chapter, we limit analysis to the accounting aspects of current assets, specifically their valuation and expense treatment.

Cash and Cash Equivalents
Cash, the most liquid asset, includes currency available and funds on deposit. Cash equivalents are highly liquid, short-term investments that are (1) readily convertible into cash and (2) so near maturity that they have minimal risk of price changes due to interest rate movements. These investments usually carry maturities of three months or less. Examples of cash equivalents are short-term treasury bills, commercial paper, and money market funds. Cash equivalents often serve as temporary repositories of excess cash.

The concept of liquidity is important in financial statement analysis. By liquidity, we mean the amount of cash or cash equivalents the company has on hand and the amount of cash it can raise in a short period of time. Liquidity provides flexibility to take advantage of changing market conditions and to react to strategic actions by competitors. Liquidity also relates to the ability of a company to meet its obligations as they mature. Many companies with strong balance sheets (where there exists substantial equity capital in relation to total assets) can still run into serious difficulties because of illiquidity.

Companies differ widely in the amount of liquid assets they carry on their balance sheets. As the graphic indicates, cash and cash equivalents as a percentage of total assets ranges from 2% (Target) to 22% (Dell). These differences can result from a numberof factors. In general, companies in a dynamic industry require increased liquidity to take advantage of opportunities or to react to a quickly changing competitive landscape
 

In addition to examining the amount of liquid assets available to the company, analysts must also consider the following:

1. To the extent that cash equivalents are invested in equity securities, companies risk a reduction in liquidity should the market value of those investmentsdecline.
2.  Cash and cash equivalents are sometimes required to be maintained as compensating balances to support existing borrowing arrangements or as collateral for indebtedness. For example, eBay, Inc., was required under the terms of a lease to place $126 million out of its $400 million in cash and investment securities as collateral for the term of the lease. These investments were, therefore, not available to meet normal operating needs of the company.

ADS