Question

(a) Comment on the validity of the following statement: “As an asset loses its ability to provide

services, cash needs to be set aside to replace it. Depreciation accomplishes this goal.” (limit

120 words)

(5 marks)

(b) How is it possible for a company to suffer a net loss for a given year, yet produce a positive

net cash flow from operating activities? (limit 120 words)

(5 marks)

(c) Describe the major purpose of a fully classified balance sheet and significant information that

can be obtained from it. (limit 120 words)

(5 marks)

(d) Cost, volume, profit analysis identifies a transaction’s “contribution’ to fixed costs.

Explain the meaning of ‘contribution’ and discuss the usefulness of such analysis in

making business decisions. (limit 120 words)

(5 marks)

(e) All else being equal, two companies in similar businesses can have the same current ratio yet

due to the composition of assets and liabilities have significantly different liquidity positions.

Discuss, referring to

a. Composition of assets and liabilities

b. the turnover of inventory and accounts receivable

(limit 120 words)

(5 marks)

Answer 1

(a)

As an asset loses its ability to provide services, cash needs to be set aside to replace it. Depreciation accomplishes this goal.

The above statement is not valid because depreciation is a non cash expense, due to which cash is not set aside for replacement of assets.

(b) Company can suffer a net loss, yet produce a positive cash flow from operating activities due to following reasons
Non Cash expenses
Finance Cost
Decrease in Current Assets
Increase in Current Liabilities

(c)
Major purpose of fully classified balance sheet is that user of balance sheet can readily extract useful information from the balance sheet.

Information that can be obatined from it are items which are listed under current assets, current liabilities, Non current Assets, Non CUrrent Liabilities and Equity.

(d)
Contribution is the excess of sales over the variable costs.
It is very useful tool for analysis in business decisions as by contribution and fixed costs we are able to calculate breakeven sales, whether it is viable to sell products or not, whether company is able to cover its fixed costs, if company is incurring losses decisions can be taken to decrease sales price so that demand can increase etc

(e)

Composition of assets and liabilities

Companies in similar businesses can have same current ratio but significantly different liquidity positions, its due to composition of its currents assets and liabilities.
Current Assets consists of Inventory, Cash, Accounts Receivables, Marketable Securities, Prepaid expenses etc.
Out of this Cash, Accounts Receivables and Marketable Securities are the assets which can be converted into cash quickly, now one business can have large amount of these current assets compared other than inventory and prepaid expenses, and other can have Lagre amount of inventory rather than cash or accounts receivables, thereby making liquidity position of one business stronger than other.

The Turnover of Inventory and accounts receivables

Liquidity position depends on how quickly the businesses can convert accounts receivables into cash and inventory into sale.
The business which have higher Inventory Turnover and accounts receivable turnover will have better liquidity position than the other business.