Essay: Intermediate Accounting When Conducting Business Operations

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Intermediate Accounting

When conducting business operations, entrepreneurs must reveal a wide series of capabilities in order to achieve their pre-established goals. They must for once be able to develop an extensive budgetary process, plan their resource consumption and adequately allocate their resources -- be them human, financial, technological or material (commodities). Another imperative necessity is given by the ability to honor the company's current liabilities, or its short-term obligations. These are extremely various and include elements such as utilities bills, employee wages or bills to providers.

There are two most common ways in which the specialized economists measure a company's ability to pay its short-term debts -- the current ratio and the quick ration. The current ratio, also called cash ratio, cash asset ratio or liquidity ratio, is calculated by dividing the current assets by the current liabilities, as revealed in the formula below:

(Investopedia, 2009)

The fact that it is measured through the division of the current assets by the current liabilities means that it strives to assess the organizational ability to pay its short-term obligations from the current assets. The current ratio is generally compared with 1 and when below, it indicates a reduced ability to pay debts and as such an organizational weakness (Investopedia).

The quick ratio is similar to the current ratio in the meaning that it also measures the company's ability to pay its short-term debts, but is different in the meaning that in assessing this ability, it considers the company's most liquid assets, rather than the current assets. It is calculated by first subtracting the inventories from the current assets, and then dividing the result by the current liabilities, as shown in the following formula:

(Investopedia)

The inventories are removed from the calculi as some companies find it extremely challenging to quickly turn their assets into liquidities; this feature makes the quick ratio more conservative and less popular than the current ratio. Similar to the first however, a higher value of the quick ratio indicates a stronger organizational position and an increased short-term liquidity (Investopedia).

1.b)

The days'-sales-in-receivables ratio measures the average number of days it takes one economic agent to recuperate its receivables from its customers; otherwise put, it measures the number of days it takes for the organizational customers to pay their debts to the entity. Changes in the days'-sales-in-receivables ratio do not necessarily generate strictly positive or strictly negative outcomes.

Given that throughout the duration of one fiscal year, Sony Corp.'s days'-sales-in-receivables ratio increased from 36 to 43 raises the necessity to understand this growth from several perspectives. First of all, it is necessary to assess it in terms of the expected ratio (auditors generally estimate and then calculate). Secondly, it is important to analyze the year's ratio in light of the ratio adherent to the previous year. Finally, it is also imperative to assess the company's days'-sales-in-receivables ratio with the average ratio within the industry (ABREMA).

If major discrepancies occur in the trend of Sony's year days'-sales-in-receivables ratio and the other ratios against which it was compared, this generally translates into an organizational weakness, which sees that the company is only limitedly capable to recuperate its receivables from its clients. Upon this realization, the manager at Sony would probably be advised to reassess the company's relation with its customers. In this endeavor, he would look at the signed contracts and ensure that the stipulated terms are being respected. It would also be possible to modify the contracts by introducing new clauses which require the clients to pay their debts to Sony within 30 business days.

1.c)

The gearing ratio is a financial ratio that measures the company in terms of its capital against its debt -- otherwise put, it strives to identify how much of a given company is the owners' capital and how much is debt (Investopedia). Relative to ABC Traders, the first gearing ratio states that for every one part of capital, two parts are debt -- this increased level of debt reveals organizational weaknesses and an increased dependence on debt, as well as increased necessity to pay the respective debt. For the second gearing ration, the numbers indicate that for every one part of capital, only 0.7 is represented by debts.

In order to best understand this information and make it relevant, it is important to compare it with industry averages and recent trends. Yet, a generalization can be made that a decreasing amount of debt is positive to the company and influences the decisions of various players. For instance, the potential investors might not have been interested in ABC Traders at the time of the first calculi, when the company revealed an impending necessity to pay back its debts. At the time of the second measurement however, the amounts of debt in the owners' capital decreased significantly, meaning that the company would be better able to pay dividends. In this order of ideas, potential investors recognize the chance of increased financial gains and are as such attracted.

A second category of stakeholders impacted by the modification in the gearing ratio is constituted by ABC Traders' competitors. These, assessing the growing internal strength of the company, might feel the need for some improvements in their own companies. Reduced levels of debt make ABC Traders stronger and as such more competitive. In order to preserve their competitive position, the other players in the industry will have to develop and implement more suitable strategies.

1.d)

As it has been mentioned throughout the previous sections, the best way of conducting an efficient and relevant analysis of financial ratios is that of comparing them with the industry averages. Companies in the same industry generally function by the same principles and will as such generate comparable ratios. Across industries however, such comparisons are less relevant and useful for the simple reason that the operations and the results are pegged to different elements.

To best understand, take the example of Company a, which is a grocery store, and that of Company B, which is a construction company. In terms of the current ratio, the value is expected to be larger for the construction company for the reason that they possess more assets and also, these assets -- land, buildings and construction materials -- are more valuable than the assets possessed by the grocery store.

In terms of inventory turnover however, the expectations are that the value will be significantly higher for the grocery store than for the construction company. The inventory turnover ratio measures the number of times a company's inventory is vended and then replaced (Investopedia). This number is significantly larger for the grocery store which may even receive new merchandize and liquidate its current stock of a given product on daily basis. Sales and replacement of the constructions firms' inventory occurs less frequently.

Finally, in terms of the rate of return on sales, this is expected to be larger for the construction company as their finite products sell for higher prices, significantly increasing as such the value of their sales.

2.

The contemporaneous manager is faced with a wide series of challenges, such as the increased emphasis on customer satisfaction or the growing need for employee on-the-job satisfaction. Yet, aside human resource and marketing, challenges also arise from the financial department and one such difficulty is given by the selection of an adequate stock valuation method. Before making the decision, it is necessary to assess three of the numerous available alternatives.

One Period Valuation Model

With the aid of this method, the stock is valued through an analysis of the discounted value of the expected cash flows according to the following formula: P0 = Div1 / (1 + ke) + P1 / (1 + ke); the price of the stock (P0) is pegged to the dividend paid at the end of the year (Div), the required return on equity investments (ke) and the price at the end of the given period (P1). For instance, if ke is 0.12, Div is 0.16 and P1 is $60, than P0 = 0.16 / 1.12 + $60 / 1.12 = $53.71.

The result is then compared to the selling price within the market and, if this is equal or lower than the identified value, the decisions is in favor of buying; if the stock is however being sold at a higher price, it means that it is overvalued and the investor will not purchase it (Kennesaw State University). In the given example, the values required for the calculi were provided, but in general circumstances, they could be difficult to attain, constituting as such for a disadvantage for this valuation method.

Derived Dividend Valuation Model

This model is in fact a variation of the previous model, with the specification that it considers more than one time periods. The formula at its basis is: P0 = D1/(1+ke) 1 + D2/(1+ke) 2 +…+ Dn/(1+ke) n + Pn/(1+ke) n (Kennesaw State University). This method is extremely complex and difficult to implement and is seldom selected for the reason that… [END OF PREVIEW]

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