Question

Answer the following:

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

b) Why might the revenue and cost of figures shown on a standard statement of comprehensive income not be representative of the actual inflows and outflows that occurred during a period?

c) In preparing a statement of financial position, why do you think standard accounting practice focuses on historical cost rather than market value?

i) Could a company's cash flow to shareholders be negative in a given year? Explain how this might come about. What about cash flow to creditors?

j) A firm's enterprise value is equal to the market value of its debt and equity, less the firm's holdings of cash and cash equivalents. This figure is particularly relevant to potential purchasers of the firm. Why?

Answer 1

a. Liquidity levels determine the ease with which a particular asset can be converted into cash. the more easilty as asset can be converted into cash it is called a highly liquid asset. The more difficult it is to convert an asset into cash it is believed that the asset is less liquid. The assets having liquidity problems cannot be easily converted into cash without suffering a loss in it's value. The more liquid assets a company possesses the less are the chances of financial distress. However, when the nature of assets a firm has is highly liquid for example cash then it is not feasable for the company to hoard lots of cash as it does not generate any income. This is the trade off between high liquidity and low liquidity.

high liquid assets leads to foregone potential profits.

b.According to the recognition and the matching principle.

the revenue generated has to be booked and the costs associated with genertaing that revenue has to be entered in the income statement when the sale is complete and not when the cash is generated or the bills are paid. According to GAAP, the revenues and its associated costs has to be entered at the time the sale is complete. Irrespective of the actual time that the cash was generated, and the costs have occured whch maybe at different time. Thus , they are not the indicators of the catual inflows or outflows.

c. Historical costs can be objectively and precisely measured , whereas the market values can be difficult to estimate as different analysts come up with different estimates. The historical costs is more objective while the market values are more relevant.

i. The cash flows for a newly established company can be negative due to the massive capital expenditures that it has incurred.

cash flow from opertaions - capital expenditures .when it is investing a lot in CAPEX, the cash flows will be negative.

It is a good sign for a newly established company but a bad sign for a already established company.

Cash flow to creditors include any repayment or addition of debt and payment of interest

suppose we made a interest payment of $5000, and the net new borrowing is 8000( debt increased from 10,000 to 18,000)

so, cash flow to creditors = interest - net new borrowings

=5000 - 8000

= -3000.

j) the enterprise value is a better indicator of the value of the firm at the time of takeover . The acquirer not only takes the company's debt but also its cash. When comparing the enterprise value with simple market value, the enterprise value is a better indicator of the value of the enterprise. It provides a better ,accurate valye due to it's inclusion of debt as the value of the debt has to be paid by the potential acquirer of the firm.