Financial Statement Analysis Cases: Occidental Petroleum

Financial Statement Analysis Casescase 1 Occidental Petroleum Corpora

Financial Statement Analysis Cases Case 1: Occidental Petroleum Corporation Occidental Petroleum Corporation reported the following information in a recent annual report. Instructions (a) What items other than coin and currency may be included in “cashâ€? (b) What items may be included in “cash equivalentsâ€? (c) What are compensating balance arrangements, and how should they be reported in financial statements? (d) What are the possible differences between cash equivalents and short-term (temporary) investments? (e) Assuming that the sale agreement meets the criteria for sale accounting, cash proceeds were $345 million, the carrying value of the receivables sold was $360 million, and the fair value of the recourse liability was $15 million, what was the effect on income from the sale of receivables? (f) Briefly discuss the impact of the transaction in (e) on Occidental’s liquidity.

Financial statement analysis plays a vital role in understanding a company's financial health and operational efficiency. In the case of Occidental Petroleum Corporation, a comprehensive review of its reported financial information, especially concerning cash and cash equivalents, reveals important insights into liquidity management and financial stability. This essay addresses critical questions related to the components of cash, cash equivalents, compensating balances, differences with short-term investments, and the impact of receivables sale transactions on income and liquidity.

Items Included in “Cash” besides Coin and Currency

Beyond physical coins and currency, “cash” in financial statements typically encompasses a variety of liquid assets readily available for use. These include demand deposits held at financial institutions, such as checking accounts, which are immediately accessible without any restrictions. Additionally, petty cash funds used for daily operational expenses are included, along with cash on hand in registers or safes. Certain deposits held by banks or other financial institutions that are available on demand also qualify as cash. It is noteworthy that some organizations may include or exclude specific items based on accounting policies, but generally, cash comprises all resources that are available for immediate expenditure.

Items Included in “Cash Equivalents”

Cash equivalents are short-term, highly liquid investments that are easily convertible into cash with minimal risk of value fluctuation. Common examples include Treasury bills, commercial paper, money market funds, and other debt instruments with original maturities of three months or less from the date of acquisition. These investments must be readily marketable and neutral with respect to interest rate fluctuations to qualify as cash equivalents. The primary criterion is their high liquidity and low risk of significant change in value, making them functionally similar to cash for the purposes of financial analysis.

Compensating Balance Arrangements and Financial Reporting

Compensating balance arrangements involve agreements where a company maintains a minimum balance in a bank account to secure a loan or banking services. These balances serve as collateral or a stipulation for borrowing arrangements and are often required by lenders to mitigate credit risk. In financial statements, compensating balances are typically disclosed separately or included within the cash or cash equivalent balances, depending on their liquidity and availability for operational use. When these balances are restricted, companies must disclose the restrictions to provide an accurate portrayal of available cash and cash equivalents, as these reserves are not freely available for general use.

Differences Between Cash Equivalents and Short-term (Temporary) Investments

While both cash equivalents and short-term investments represent liquid assets, key differences exist. Cash equivalents are highly liquid, low-risk instruments with maturities of three months or less, designed for immediate use. In contrast, short-term (temporary) investments are debt or equity securities intended to be held for a slightly longer period, generally exceeding three months but less than a year. These investments might have higher yields but involve slightly more risk and less liquidity than cash equivalents. The classification depends on the company's intent and the nature of the investment, with short-term investments sometimes being classified separately on the balance sheet.

Effect of Sale Agreement on Income from Receivables

In the scenario where a company sells receivables, the impact on income depends on whether the sale qualifies for sale accounting under accounting standards such as ASC 860 or IFRS. Assuming it does, the cash proceeds from sale are recognized, but the initial carrying amount of receivables (cost basis) is removed from the books. The sale resulted in a cash inflow of $345 million, while the receivables' carrying value was $360 million, with a recourse liability fair value of $15 million. The difference between the carrying amount and cash received, adjusted for liabilities, results in a loss of $30 million ($360 million – $345 million), minus the fair value of the recourse liability ($15 million), which impacts income accordingly. Therefore, the net effect on income is a loss of approximately $30 million, affecting net income negatively.

Impact on Occidental’s Liquidity

The sale of receivables under such circumstances enhances Occidental’s liquidity by converting illiquid assets into cash, which can be used to fund operations, reduce debt, or pursue expansion. However, the sale's impact also depends on the recourse liabilities and associated risks. The recourse liability of $15 million indicates potential future obligations, which need to be considered when evaluating liquidity. Nonetheless, cash inflow from such sales generally strengthens short-term liquidity, improves cash flow ratios, and provides buffer for operational needs. The quick conversion of receivables into cash also indicates effective receivables management and contributes to a healthier liquidity position, though it might reduce future revenue streams if receivables sales become frequent.

Conclusion

Understanding the nuances of cash and cash equivalents, as well as the accounting treatment of receivables sales, is essential for stakeholders analyzing Occidental Petroleum's financial health. Recognizing the components of cash, the nature of cash equivalents, and the implications of receivables sales provides a comprehensive view of liquidity management. While selling receivables improves immediate liquidity, it introduces risks and impacts income, necessitating careful scrutiny of such transactions. Overall, effective liquidity management strategies incorporating these elements are vital for sustaining financial stability and supporting corporate growth objectives.

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