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Chapter 6: Problem 1

What does the term \(c a s h,\) as shown on financial statements, usually include? Discuss \(c a s h,\) and \(c a s h,\) equivalents separately.

Short Answer

Expert verified
On financial statements, 'cash' typically refers to a company's physical currency and demand deposits, usable immediately, with no risk. 'Cash equivalents' are short-term, low-risk investments that can be converted into a known cash amount within a short period, typically three months or less. They are subject to an insignificant risk of changes in value and may include treasury bills, marketable securities, and money market funds.

Step by step solution

01

Defining Cash

Cash, as shown on the financial statements, refers to the company's currency, which comprises banknotes and coins, and also includes demand deposits with banks or other financial institutions. Cash can be used immediately and involves no risk.
02

Defining Cash Equivalents

Cash equivalents are short-term investments that a company can quickly convert into cash, typically within three months or less. They are highly liquid and carry low risk for change in value. Examples include treasury bills, marketable securities, and money market funds.
03

Differentiating Cash and Cash Equivalents

While both cash and cash equivalents can be used to meet a company's financial obligations, they differ in terms of their liquidity and levels of risk. Cash is readily available for use, while cash equivalents require some effort (although minimal) to be converted into cash. Also, cash carries no risk, whereas cash equivalents carry minor risks, as their value can slightly fluctuate.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Cash Equivalents
Cash Equivalents are financial assets that a company can quickly transform into cash, typically within a three-month period or less. These are not cash itself but provide a level of liquidity almost equivalent to cash. Such assets are highly valued in the financial world for their ability to be converted swiftly, providing flexibility and peace of mind. Examples of cash equivalents include:
  • Treasury bills, which are short-term government securities with a maturity of less than one year.
  • Commercial paper issued by companies to finance their short-term needs.
  • Money market funds, which provide quick access to cash with minimal risk.
All these instruments are considered to have low risk because their price does not change significantly over a short period. They offer businesses a means to manage excess cash efficiently, allowing them to respond quickly to financial opportunities or emergencies.
Financial Statements
Financial Statements serve as a snapshot of a company's financial health. They provide essential information about financial performance, position, and cash flows. There are three primary types of financial statements:
  • Balance Sheet: This statement reflects the company's assets, liabilities, and equity at a specific point in time. It provides a picture of what the company owns and owes.
  • Income Statement: Also known as the profit and loss statement, it details a company's revenues and expenses over a period, showing how much money the company earned or lost.
  • Cash Flow Statement: It shows how changes in the balance sheet and income affect cash and cash equivalents. It highlights the company's liquidity and cash management.
These statements are essential for stakeholders like investors, creditors, and management to make informed decisions regarding the company's financial standing and future actions. Understanding these components can greatly enhance a person's ability to assess a company's health and prospects.
Liquidity
Liquidity is a measure of how quickly an asset can be converted into cash without affecting its price. It is a critical factor in finance and investing, as it represents the ease with which an entity can meet its short-term obligations. There are a few key points to understand regarding liquidity:
  • High Liquidity: This means assets can be sold quickly and without a significant impact on their value, for example, cash and cash equivalents.
  • Low Liquidity: Assets like real estate, which may take time to sell, fall under this category as they cannot be quickly converted into cash without potentially losing value.
  • Importance: Liquidity is crucial for maintaining a company's operational stability and solvency. A company with good liquidity can easily manage unforeseen expenses and seize investment opportunities.
In financial statements, liquidity ratios like the current ratio or quick ratio help measure a company's ability to cover short-term liabilities, giving insight into their financial flexibility.
Risk Management
Risk Management is a fundamental component of business strategy. It involves identifying, assessing, and prioritizing risks, which may affect a company's finances or operations. Effective risk management plays a major role in ensuring the sustainability of a company. There are several ways businesses manage risk:
  • Risk Avoidance: Efforts to avoid activities that may lead to risk.
  • Risk Reduction: Implementing measures to reduce the impact or likelihood of risks, such as using insurance.
  • Risk Sharing: Transferring or sharing risks with other parties, perhaps through contracts or outsourcing.
  • Risk Retention: Sometimes, businesses accept certain risks, often because the cost of avoiding them is higher than the risk itself.
By evaluating the different kinds of risks, including financial, operational, and strategic, companies can prepare and protect themselves from potential adverse effects that could hinder their operations or profitability. Effective risk management is key to achieving company goals and ensuring long-term success.

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Most popular questions from this chapter

Calculate the gross profit percentages for each of the following situations and, based on these results, identify which situations are most preferable:a. sales of \(\$ 450,000,\) cost of goods sold of \(\$ 300,000\) b. Sales of \(\$ 660,000,\) gross profit of \(\$ 230,000\) c. Sales of \(\$ 700,000,\) gross profit of \(\$ 330,000\) d. Sales of \(\$ 800,000,\) gross profit ratio of \(25 \%\)

Firm A has an accounts receivable balance of 126,000 dollars and a balance in its allowance for uncollectible accounts of 29,000 dollars. Contrast this situation with Firm B, which has corresponding balances of \(\$ 963,000\) and \(\$ 865,000\). Which firm is riskier? Why? Which firm do you think is doing a better job of managing its accounts receivable? Why?

Sheila Glow sells advertising for \(\mathrm{KBOL}\), a local radio station. She receives a small monthly salary plus a commission of \(20 \%\) of all advertising contracts that she negotiates and that are billed by KBOL. KBOL conducts an informal credit review on all new clients, but relies extensively on the salesperson's recommendations. Because Sheila interviews the owner and chief financial officer (CFO) of all her new clients, she feels that her credit screening should be an adequate basis on which KBOL could reliably determine whether to accept or reject a potential client's credit request.One potential new client,Atlas Tile Company, has been experiencing financial difficulties and several letters to the editors from disgruntled customers have recently appeared in the local newspaper.Although Sheila knows that Atlas needs many new customers, her commissions have not been strong this month compared to prior months.KBOL always has the right to reject Atlas's credit application. Sheila knows that if the credit application contains favorable information, it is likely to be accepted. In the process of helping Atlas' CFO complete the application, she suggests that City Bank's rejection of Atlas' loan application for \(\$ 5,000\) worth of working capital not be shown on the current application for KBOL's credit. She reasons that Atlas needs her help, and it is not her job to collect the bills; it is only her job to sell radio advertising.a. What are the ethical ramifications of Sheila's actions? b. What are the likely business results of Sheila's actions? c. How does KBOL's commission policy affect Sheila's incentives? d. How might the commission policy be changed to more closely align Sheila's incentives with KBOL's goals? e. If the radio station's managers find that Sheila helped falsify the credit report, what should they do? Why?

In the HMO industry, accounts receivable represent one of the major assets. HMOs provide medical services to patients and then bill insurance companies and Medicare/Medicaid agencies. Timely collection is important to maintaining adequate liquidity. Locate the latest 10 -K filings for Columbia/HCA Healthcare and FHP International, using the EDGAR archives.a. What is the value of net accounts receivable? What percent of total assets and current assets do they represent for each company? b. What is the value of allowance for uncollectible accounts and what percentage of gross accounts receivable does it represent? c. What are the net revenues for each HMO? Which HMO is larger? d. Calculate the accounts receivable collection period for both companies. e. Which company is doing a better job with its accounts receivable?

The Atlas Tile Company has an accounts receivable balance at December 31 of 376,000 .dollars Its allowance for uncollectible accounts, before adjustment, has a balance of 37,000 dollas . Credit sales for Atlas, for the year just ended, were 2,700,000 dollars Using its credit history, Atlas decides to increase its allowance account by \(3 \%\) of credit sales.a. Calculate the allowance for uncollectible accounts as a percentage of the accounts receivable ratio, both before and after the \(3 \%\) adjustment was made. b. Now assume that the firm's auditors have conducted an aging analysis and recommend that the allowance account balance be increased to \(\$ 96,000 .\) Recalculate the allowance for uncollectible accounts as a percentage of accounts receivable ratio after this alternative adjustment has been made. c. Compare and contrast these results.
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