You work as part of a team that selects parts suppliers for a large manufacturer. Your company is highly dependent on your suppliers, and you want long-term relationships. You want suppliers who are financially stable, without cash flow problems. If they need more capacity in order to grow with you, you want them to be able to attract additional investors.
One of your team members claims that financial statements tell you everything you need to know to determine the future stability and growth potential of a supplier. Another claims that financial statements are useless in the process, and that talking with the people in the company is the only route to judging its future.
1. Discuss the strengths and weaknesses of financial statements in assisting you as you try to determine the stability and growth potential of possible suppliers.
2. What can you learn about a company from a standard set of financial statements?
3. What are the limitations of financial statements?
4. What would you look at in the statements to judge a supplier’s ability to remain in business and avoid cash flow problems?
5. What relationships in the statements would help you judge whether the company could attract additional capital for growth?
It is late summer and General Wheels, Inc., an auto manufacturer, is facing a financial crisis. A large issue of bonds payable will mature next March, and the company must issue stock or new bonds to raise the money to retire this debt. Unfortunately, profits and cash flows have been declining over recent years. Management fears that if cash flows and profits do not improve in the current year, the company will not be able to raise the capital needed to replace the maturing bonds. Therefore, members of management have made the following proposals to improve the cash flows and profitability that will be reported in the financial statements dated this coming December 31.
1. Switch from the LIFO method to the FIFO method of valuing inventories.Management estimates that the FIFO method will result in a lower cost of goods sold but in higher income taxes for the current year. However, the additional income taxes will not actually be paid until early next year.
2. Switch from the 150 percent declining-balance method of depreciation to the straight- line method and lengthen the useful lives over which assets are depreciated. (These changes would be made only for financial reporting purposes, not for income tax purposes.)
3. Pressure dealers to increase their inventories—in short, to buy more cars. (The dealerships are independently owned; thus dealers are the customers to whom General Wheels sells automobiles.) Management estimates that this strategy could increase sales for the current year by 5 percent. However, any additional sales in the current year would be almost entirely offset by fewer sales in the following year.
4. Require dealers to pay for purchases more quickly. Currently, dealers must pay for purchases of autos within 60 days. Management is considering reducing this period to 30 days.
5. Borrow at current short-term interest rates (about 10 percent) and use the proceeds to pay off long-term debt bearing an interest rate of 13 percent.
6. Substitute stock dividends for the cash dividends currently paid on capital stock.
a. Prepare a schedule with four columns. The first column is to be headed “Proposals” and is to contain the paragraph numbers of the six proposals listed above. The next three columns are to be headed with the following financial statement captions: (1) “Net Income,” (2) “Net Cash Flows from Operating Activities,” and (3) “Cash.”
For each of the six proposals in the left-hand column, indicate whether you expect the proposal to “Increase,” “Decrease,” or have “No Effect” in the current year on each of the financial statement captions listed in the next three columns. (Note: Only a few months remain in the current year. Therefore, you are to determine the short-term effects of these proposals.)
b. For each of the six proposals, write a short paragraph explaining the reasoning behind your answers to part a.
You are a staff accountant for Pearce, Pearce, and Smith, CPAs, and have worked for several years on the audit of a major client of the firm, Flexcom, Inc. Flexcom sells its products in a highly competitive market and relies heavily on the careful management of inventory because of the unique nature of the products sold and the importance of minimising the company’s investment in inventory. Flexcom sells cellular phones, personal handheld computers, and other communications devices that are particularly sensitive to changes in consumer demands and changes in technology, which are both frequent and significant in terms of their impact on the attractiveness of Flexcom’s products to buyers.
In the course of your work, you have noticed several trends related to inventory that interest you and that have caused you to explore further the underlying details. Specifically, you have determined the following:
Despite sluggish sales volume, the company’s net income has steadily increased for each of the last three years.
Inventory has been increasing at a higher-than-normal rate.
The allowance to reduce inventory for obsolescence has dramatically declined during the last three years, going from nearly 10 percent of inventory three years ago to approximately 2 percent at the end of the most recent year.
You are aware that, within Flexcom, profitability is a major factor in the evaluation of management and has been cited in at least two recent situations as the basis for replacing individuals in leadership positions.
Discuss why you are bothered by these trends and offer one or more explanations that may underlie what is actually going on within Flexcom. (Your explanations may be based on some assumptions of what is going on).