Question

7. What does liquidity measure? Explain the trade-off a firm faces between high liquidity and low liquidity levels.

8. In preparing a balance sheet, why do you think standard accounting practice focuses on historical cost rather than market value?

9. In comparing accounting net income and operating cash flow, name two items you typically find in net income that are not in operating cash flow. Explain what each is and why it is excluded in operating cash flow.

10. Under standard accounting rules, it is possible for a company’s liabilities to exceed its assets. When this occurs, the owners’ equity is negative. Can this happen with market values? Why or why not?

11. Suppose a company’s cash flow from assets is negative for a particular period. Is this necessarily a good sign or a bad sign?

12. Suppose a company’s operating cash flow has been negative for several years running. Is this necessarily a good sign or a bad sign?

13. Could a company’s cash flow to stockholders be negative in a given year? ( Hint: Yes.) Explain how this might come about. What about cash flow to creditors?

Answer 1

Answer:

7) Liquidity measures how quickly and easily an asset can be converted to cash without significant loss in value. It's desirable for firms to have high liquidity so that they can more safely meet short-term creditor demands. However, liquidity also has an opportunity cost. Firms generally reap higher returns by investing in illiquid, productive assets. It's up to the firm's financial management staff to find a reasonable compromise between these opposing needs.

8) Historical costs can be objectively and precisely measured, whereas market values can be difficult to estimate, and different analysts would come up with different numbers. Thus, there is a tradeoff between relevance (market values) and objectivity (book values).

9) Depreciation is a non-cash deduction that reflects adjustments made in asset book values in accordance with the matching principle in financial accounting. Interest expense is a cash outlay, but it's a financing cost, not an operating cost.

10) Market values can never be negative. Imagine a share of stock selling for -$20. This would mean that if you placed an order for 100 shares, you would get the stock along with a check for $2,000. How many shares do you want to buy? More generally, because of corporate and individual bankruptcy laws, net worth for a person or a corporation cannot be negative, implying that liabilities cannot exceed assets in market value.

11) For a successful company that is rapidly expanding, for example, capital outlays will be large, possibly leading to negative cash flow from assets. In general, what matters is whether the money is spent wisely, not whether cash flow from assets is positive or negative.

12) It's probably not a good sign for an established company, but it would be fairly ordinary for a start-up, so it depends.

13) If a company raises more money from selling stock than it pays in dividends in a particular period, its cash flow to stockholders will be negative. If a company borrows more than it pays in interest, its cash flow to creditors will be negative.