Textual Learning Material - Module 4

98 Financial Reporting & Decision Making
Unit 4: Liquidity of Short-term Assets

Notes
Structure
4.1 Introduction
4.2 Financial Ratios: As Perceived by Corporate Controllers
4.2.1 Most significant ratios and their primary measure
4.2.2 Key financial ratios included as Corporate Objectives
4.2.3 Financial Ratios used in Annual Reports
4.3 Related Debt Paying Ability & Long-term Debt-paying Ability
4.3.1 Current Assets
4.3.2 Current liabilities
4.3.3 The Operating cycle
4.3.4 Current Assets Compared with Current liabilities
4.3.5 Working capital
4.3.6 Current ratio
4.3.7 Acid test ratio
4.3.8 Cash ratio
4.4 Other Liquidity Consideration
4.4.1 Sales to working capital turnover ratio
4.4.2 Income statement consideration when determining debt-paying ability
4.5 Balance Sheet Consideration when Determining Debt-paying Ability
4.6 Summary
4.7 Check Your Progress
4.8 Questions and Exercises
4.9 Key Terms
4.10 Further Readings
Objectives
After studying this unit, you should be able to:
 Understand the Financial ratios As perceived by corporate controllers
 Discuss Related debt paying ability & Long-term Debt-paying Ability
 Explain Other liquidity consideration
4.1 Introduction
Since the short-term debt-paying ability is a very important indicator of the enterprise
stability, the liquidity ratio analysis becomes a useful method of analyzing firm’s
Amity Directorate of Distance & Online Education

Liquidity of Short-term Assets 99
performance. The ability to pay current obligations means there is a higher chance
company can also maintain a long-term debt-paying ability and not find itself bankrupt
because of not being able to meet its obligations to short-term creditors. Having Notes
systematic troubles meeting its short-term obligations means a higher risk of firm’s
bankruptcy, thus calculating the liquidity ratios and analyzing the results is highly
important both for company owners and for potential investors.
Liquidity ratio calculation and analysis
Current Ratio
The formula for the current ratio is as follows:
Current Ratio = Current Assets ÷ Current Liabilities
The current ratio indicates a firm's ability to pay its current liabilities from its current
assets. This is the basic indicator of the company’s liquidity. Higher numbers are better,
meaning that the current assets amount of a firm is higher comparing to current
liabilities and thus, company has the ability to easily pay off its short-term debt.
Generally, the normal value for this ratio is 2 or more, however, the comparison with
other similar companies should necessarily be made, because for some industries
values below 2 are adequate.
Quick Ratio (Acid Test Ratio)

The purpose of calculating the quick ratio (also referred as acid test ratio) is to measure
how well a company can meet its short-term obligations with its most liquid assets:
Quick Ratio = (Cash Equivalents + Marketable Securities + Net Receivables) ÷ Current
Liabilities
This formula can be used for the most conservative ratio calculation when one
needs to exclude items that don’t represent current cash flow from current assets. The
normal value for this ratio is 1, but as with current ratio, the comparison with similar
companies should be made, because in some industries firms with quick ratio below 1
still have normal liquidity.
A common alternative formula for acid test ratio is:
Quick Ratio = (Cash + Marketable Securities + Accounts and Notes Receivable) ÷
Current Liabilities
This formula provides you an indication of the business liquidity by comparing the
amount of cash, marketable securities and accounts and notes receivable to current
liabilities. Should also be mentioned, that the quick ratio does not include inventory and
prepaid expenses in the calculation, which is the main difference between the current
ratio and the quick ratio.
Finally, another formula for calculating quick ratio exists, which is more general:
Quick Ratio = (Current assets - Inventory) ÷ Current liabilities
The quick ratio allows to focus on quick assets (those that could be quickly
converted to cash), that’s why it keeps inventories out of equation. Once again, the
normal value for this ratio is 1 or more, meaning that for every dollar of company’s
current liabilities the firm has at least 1 dollar of very liquid assets to cover those
immediately, if needed.
Cash Ratio
A way of company’s cash and equivalents amount estimation in terms of liquidity is the
calculation of the cash ratio. That can be done using the following formula:
Cash Ratio = (Cash Equivalents + Marketable Securities) ÷ Current Liabilities

The cash ratio is the most conservative indicator of firm’s liquidity, indicating its
immediate liquidity. Having calculated the cash ratio one can see how well a company
Notes can pay off its current liabilities with only cash and cash equivalents. However, it is not
realistic to expect the company to have enough cash and equivalents to cover all the
current liabilities, because if this occurs, it means that the company’s usage of cash is
not efficient as cash should rather be put to work in the operations of the firm.
Considering this, the detailed knowledge of the business is required to have a chance to
draw a conclusion based on the cash ratio calculation. Most commonly, big values of
cash ratio would mean inappropriate usage of cash by the company, while cash ratio
lesser than 0.2 would mean that the firm might face an immediate problem with paying
bills.
Working Capital
Company’s working capital indicates its short-run solvency and financial sustainability.
The calculation formula for the working capital as follows:
Working Capital = Current Assets - Current Liabilities
The working capital amount is a value that should be compared with past periods of
time within the same company to determine its reasonability, while comparing the
working capital amount of different companies is pointless due to the different sizes of
firms. Current assets are assets that are expected to be turned into cash by a company
within one year, or one business cycle. Analogically, current liabilities are liabilities that
are expected to be paid by a firm within a year, or one business cycle. Financially
sustainable business would be able to pay its current liabilities with its current assets.
Sales to Working Capital (Working Capital Turnover)

A part of liquidity ratio analysis is the calculation of sales to working capital (also
referred as working capital turnover). The formula for doing that is as follows:
Sales to Working Capital = Sales ÷ Average Working Capital
The sales to working capital ratio indicate how much cash is needed to generate a
certain level of sales. In other words, it measures dollars of sales generated by a dollar
of working capital investment. That’s why a low working capital turnover ratio most likely
indicates an unprofitable use of working capital. In other words, sales are not adequate
in relation to the available working capital. As with many other ratios, before drawing a
conclusion based on sales to working capital ratio, one should make a comparison with
other similar companies, industry averages, to compare the dynamics of this ratio
comparing to past periods of time. Seeing the increase of sales to working capital in
dynamics over some period would witness the overall increase of liquidity of the firm.
Liquidity ratios are the ratios that measure the ability of a company to meet its short
term debt obligations. These ratios measure the ability of a company to pay off its short-
term liabilities when they fall due.
The liquidity ratios are a result of dividing cash and other liquid assets by the short
term borrowings and current liabilities. They show the number of times the short term
debt obligations are covered by the cash and liquid assets. If the value is greater than 1,
it means the short term obligations are fully covered.
Generally, the higher the liquidity ratios are, the higher the margin of safety that the
company possesses to meet its current liabilities. Liquidity ratios greater than 1 indicate
that the company is in good financial health and it is less likely fall into financial
difficulties.
Most common examples of liquidity ratios include current ratio, acid test ratio (also
known as quick ratio), cash ratio and working capital ratio. Different assets are
considered to be relevant by different analysts. Some analysts consider only the cash
and cash equivalents as relevant assets because they are most likely to be used to
meet short term liabilities in an emergency. Some analysts consider the debtors and

trade receivables as relevant assets in addition to cash and cash equivalents. The value
of inventory is also considered relevant asset for calculations of liquidity ratios by some
analysts. Notes
The concept of cash cycle is also important for better understanding of liquidity
ratios. The cash continuously cycles through the operations of a company. A company’s
cash is usually tied up in the finished goods, the raw materials, and trade debtors. It is
not until the inventory is sold, sales invoices raised, and the debtors’ make payments
that the company receives cash. The cash tied up in the cash cycle is known as working
capital, and liquidity ratios try to measure the balance between current assets and
current liabilities.
A company must possess the ability to release cash from cash cycle to meet its
financial obligations when the creditors seek payment. In other words, a company
should possess the ability to translate its short term assets into cash. The liquidity ratios
attempt to measure this ability of a company.
4.2 Financial Ratios: As Perceived by Corporate Controllers

When it comes to investing, analyzing financial statement information (also known as
quantitative analysis), is one of, if not the most important element in the fundamental
analysis process. At the same time, the massive amount of numbers in a company's
financial statements can be bewildering and intimidating to many investors. However,
through financial ratio analysis, you will be able to work with these numbers in an
organized fashion.
The objective of this tutorial is to provide you with a guide to sources of financial
statement data, to highlight and define the most relevant ratios, to show you how to
compute them and to explain their meaning as investment evaluators.
In this regard, we draw your attention to the complete set of financials for Zimmer
Holdings, Inc. (ZMH), a publicly listed company on the NYSE that designs,
manufactures and markets orthopedic and related surgical products, and fracture-
management devices worldwide. We've provided these statements in order to be able
to make specific reference to the account captions and numbers in Zimmer's financials
in order to illustrate how to compute all the ratios.
Among the dozens of financial ratios available, we've chosen 30 measurements
that are the most relevant to the investing process and organized them into six main
categories as per the following list:
1. Liquidity Measurement Ratios
 Current Ratio
 Quick Ratio
 Cash Ratio
 Cash Conversion Cycle
2. Profitability Indicator Ratios
 Profit Margin Analysis
 Effective Tax Rate
 Return On Assets
 Return On Equity
 Return On Capital Employed
3. Debt Ratios
 Overview Of Debt
 Debt Ratio
 Debt-Equity Ratio

 Capitalization Ratio
Interest Coverage Ratio
Notes 
 Cash Flow To Debt Ratio
4. Operating Performance Ratios
 Fixed-Asset Turnover
 Sales/Revenue Per Employee
 Operating Cycle
5. Cash Flow Indicator Ratios
 Operating Cash Flow/Sales Ratio
 Free Cash Flow/Operating Cash Ratio
 Cash Flow Coverage Ratio
 Dividend Payout Ratio
6. Investment Valuation Ratios
 Per Share Data
 Price/Book Value Ratio
 Cash Flow Coverage Ratio
 Price/Earnings Ratio
 Price/Earnings To Growth Ratio
 Price/Sales Ratio
 Dividend Yield
 Enterprise Value Multiple
Financial ratios are relationships determined from a company's financial information
and used for comparison purposes. Examples include such often referred to measures
as return on investment (ROI), return on assets (ROA), and debt-to-equity, to name just
three. These ratios are the result of dividing one account balance or financial
measurement with another. Usually these measurements or account balances are
found on one of the company's financial statements—balance sheet, income statement,
cash flow statement, and/or statement of changes in owner's equity. Financial ratios can
provide small business owners and managers with a valuable tool with which to
measure their progress against predetermined internal goals, a certain competitor, or
the overall industry. In addition, tracking various ratios over time is a powerful means of
identifying trends in their early stages. Ratios are also used by bankers, investors, and
business analysts to assess a company's financial status.
Ratios are calculated by dividing one number by another, total sales divided by
number of employees, for example. Ratios enable business owners to examine the
relationships between items and measure that relationship. They are simple to
calculate, easy to use, and provide business owners with insight into what is happening
within their business, insights that are not always apparent upon review of the financial
statements alone. Ratios are aids to judgment and cannot take the place of experience.
But experience with reading ratios and tracking them over time will make any manager
a better manager. Ratios can help to pinpoint areas that need attention before the
looming problem within the area is easily visible.
Virtually any financial statistics can be compared using a ratio. In reality, however,
small business owners and managers only need to be concerned with a small set of
ratios in order to identify where improvements are needed.
It is important to keep in mind that financial ratios are time sensitive; they can only
present a picture of the business at the time that the underlying figures were prepared.
For example, a retailer calculating ratios before and after the Christmas season would
get very different results. In addition, ratios can be misleading when taken singly,

though they can be quite valuable when a small business tracks them over time or uses
them as a basis for comparison against company goals or industry standards.
Notes
Perhaps the best way for small business owners to use financial ratios is to conduct
a formal ratio analysis on a regular basis. The raw data used to compute the ratios
should be recorded on a special form monthly. Then the relevant ratios should be
computed, reviewed, and saved for future comparisons. Determining which ratios to
compute depends on the type of business, the age of the business, the point in the
business cycle, and any specific information sought. For example, if a small business
depends on a large number of fixed assets, ratios that measure how efficiently these
assets are being used may be the most significant. In general, financial ratios can be
broken down into four main categories—
1. Profitability or return on investment;
2. Liquidity;
3. Leverage, and
4. Operating or efficiency—with several specific ratio calculations prescribed within
each.
Profitability or Return on Investment Ratios

Profitability ratios provide information about management's performance in using the
resources of the small business. Many entrepreneurs decide to start their own
businesses in order to earn a better return on their money than would be available
through a bank or other low-risk investments. If profitability ratios demonstrate that this
is not occurring—particularly once a small business has moved beyond the start-up
phase—then entrepreneurs for whom a return on their money is the foremost concern
may wish to sell the business and reinvest their money elsewhere. However, it is
important to note that many factors can influence profitability ratios, including changes
in price, volume, or expenses, as well as the purchase of assets or the borrowing of
money. Some specific profitability ratios follow, along with the means of calculating
them and their meaning to a small business owner or manager.
 Gross profitability: Gross Profits/Net Sales—measures the margin on sales the
company is achieving. It can be an indication of manufacturing efficiency, or
marketing effectiveness.
 Net profitability: Net Income/Net Sales—measures the overall profitability of the
company, or how much is being brought to the bottom line. Strong gross profitability
combined with weak net profitability may indicate a problem with indirect operating
expenses or non-operating items, such as interest expense. In general terms, net
profitability shows the effectiveness of management. Though the optimal level
depends on the type of business, the ratios can be compared for firms in the same
industry.
 Return on assets: Net Income/Total Assets—indicates how effectively the
company is deploying its assets. A very low return on asset, or ROA, usually
indicates inefficient management, whereas a high ROA means efficient
management. However, this ratio can be distorted by depreciation or any unusual
expenses.
 Return on investment 1: Net Income/Owners' Equity—indicates how well the
company is utilizing its equity investment. Due to leverage, this measure will
generally be higher than return on assets. ROI is considered to be one of the best
indicators of profitability. It is also a good figure to compare against competitors or
an industry average. Experts suggest that companies usually need at least 10-14
percent ROI in order to fund future growth. If this ratio is too low, it can indicate poor
management performance or a highly conservative business approach. On the
other hand, a high ROI can mean that management is doing a good job, or that the
firm is undercapitalized.

 Return on investment 2: Dividends +/- Stock Price Change/Stock Price Paid—

from the investor's point of view, this calculation of ROI measures the gain (or loss)
Notes achieved by placing an investment over a period of time.
 Earnings per share: Net Income/Number of Shares Outstanding—states a
corporation's profits on a per-share basis. It can be helpful in further comparison to
the market price of the stock.
 Investment turnover: Net Sales/Total Assets—measures a company's ability to
use assets to generate sales. Although the ideal level for this ratio varies greatly, a
very low figure may mean that the company maintains too many assets or has not
deployed its assets well, whereas a high figure means that the assets have been
used to produce good sales numbers.
 Sales per employee: Total Sales/Number of Employees—can provide a measure
of productivity. This ratio will vary widely from one industry to another. A high figure
relative to one's industry average can indicate either good personnel management
or good equipment.
Liquidity Ratios
Liquidity ratios demonstrate a company's ability to pay its current obligations. In other
words, they relate to the availability of cash and other assets to cover accounts payable,
short-term debt, and other liabilities. All small businesses require a certain degree of
liquidity in order to pay their bills on time, though start-up and very young companies
are often not very liquid. In mature companies, low levels of liquidity can indicate poor
management or a need for additional capital. Any company's liquidity may vary due to
seasonality, the timing of sales, and the state of the economy. But liquidity ratios can
provide small business owners with useful limits to help them regulate borrowing and
spending. Some of the best-known measures of a company's liquidity include:
 Current ratio: Current Assets/Current Liabilities—measures the ability of an entity
to pay its near-term obligations. "Current" usually is defined as within one year.
Though the ideal current ratio depends to some extent on the type of business, a
general rule of thumb is that it should be at least 2:1. A lower current ratio means
that the company may not be able to pay its bills on time, while a higher ratio means
that the company has money in cash or safe investments that could be put to better
use in the business.
 Quick ratio (or "acid test"): Quick Assets (cash, marketable securities, and
receivables)/Current Liabilities—provide a stricter definition of the company's ability
to make payments on current obligations. Ideally, this ratio should be 1:1. If it is
higher, the company may keep too much cash on hand or have a poor collection
program for accounts receivable. If it is lower, it may indicate that the company
relies too heavily on inventory to meet its obligations.
 Cash to total assets: Cash/Total Assets—measures the portion of a company's
assets held in cash or marketable securities. Although a high ratio may indicate
some degree of safety from a creditor's viewpoint, excess amounts of cash may be
viewed as inefficient.
 Sales to receivables (or turnover ratio): Net Sales/Accounts Receivable—
measures the annual turnover of accounts receivable. A high number reflects a
short lapse of time between sales and the collection of cash, while a low number
means collections take longer. Because of seasonal changes this ratio is likely to
vary. As a result, an annual floating average sales to receivables ratio is most
useful in identifying meaningful shifts and trends.
 Days' receivables ratio: 365/Sales to receivables ratio—measures the average
number of days that accounts receivable are outstanding. This number should be
the same or lower than the company's expressed credit terms. Other ratios can also
be converted to days, such as the cost of sales to payables ratio.

 Cost of sales to payables: Cost of Sales/Trade Payables—measures the annual
turnover of accounts payable. Lower numbers tend to indicate good performance,
though the ratio should be close to the industry standard. Notes
 Cash turnover: Net Sales/Net Working Capital (current assets less current
liabilities)—reflects the company's ability to finance current operations, the
efficiency of its working capital employment, and the margin of protection for its
creditors. A high cash turnover ratio may leave the company vulnerable to creditors,
while a low ratio may indicate an inefficient use of working capital. In general, sales
five to six times greater than working capital are needed to maintain a positive cash
flow and finance sales.
Leverage Ratios
Leverage ratios look at the extent to which a company has depended upon borrowing to
finance its operations. As a result, these ratios are reviewed closely by bankers and
investors. Most leverage ratios compare assets or net worth with liabilities. A high
leverage ratio may increase a company's exposure to risk and business downturns, but
along with this higher risk also comes the potential for higher returns. Some of the major
measurements of leverage include:
 Debt to equity ratio: Debt/Owners' Equity—indicates the relative mix of the
company's investor-supplied capital. A company is generally considered safer if it
has a low debt to equity ratio—that is, a higher proportion of owner-supplied
capital—though a very low ratio can indicate excessive caution. In general, debt
should be between 50 and 80 percent of equity.
 Debt ratio: Debt/Total Assets—measures the portion of a company's capital that is
provided by borrowing. A debt ratio greater than 1.0 means the company has
negative net worth, and is technically bankrupt. This ratio is similar, and can easily
be converted to, the debt to equity ratio.
 Fixed to worth ratio: Net Fixed Assets/Tangible Net Worth—indicates how much
of the owner's equity has been invested in fixed assets, i.e., plant and equipment. It
is important to note that only tangible assets (physical assets like cash, inventory,
property, plant, and equipment) are included in the calculation, and that they are
valued less depreciation. Creditors usually like to see this ratio very low, but the
large-scale leasing of assets can artificially lower it.
 Interest coverage: Earnings before Interest and Taxes/Interest Expense—
indicates how comfortably the company can handle its interest payments. In
general, a higher interest coverage ratio means that the small business is able to
take on additional debt. This ratio is closely examined by bankers and other
creditors.
Efficiency Ratios
By assessing a company's use of credit, inventory, and assets, efficiency ratios can
help small business owners and managers conduct business better. These ratios can
show how quickly the company is collecting money for its credit sales or how many
times inventory turns over in a given time period. This information can help
management decide whether the company's credit terms are appropriate and whether
its purchasing efforts are handled in an efficient manner. The following are some of the
main indicators of efficiency:
 Annual inventory turnover: Cost of Goods Sold for the Year/Average Inventory—
shows how efficiently the company is managing its production, warehousing, and
distribution of product, considering its volume of sales. Higher ratios—over six or
seven times per year—are generally thought to be better, although extremely high
inventory turnover may indicate a narrow selection and possibly lost sales. A low
inventory turnover rate, on the other hand, means that the company is paying to
keep a large inventory, and may be overstocking or carrying obsolete items.

 Inventory holding period: 365/Annual Inventory Turnover—calculates the number

of days, on average, that elapse between finished goods production and sale of
Notes product.
 Inventory to assets ratio Inventory/Total Assets—shows the portion of assets
tied up in inventory. Generally, a lower ratio is considered better.
 Accounts receivable turnover Net (credit) Sales/Average Accounts
Receivable—gives a measure of how quickly credit sales are turned into cash.
Alternatively, the reciprocal of this ratio indicates the portion of a year's credit sales
that are outstanding at a particular point in time.
 Collection period 365/Accounts Receivable Turnover—measures the average
number of days the company's receivables are outstanding, between the date of
credit sale and collection of cash.
What are the key financial ratios to know when going through financial
statements of any company?
External rather than internal stakeholders of a company are most interested in the
analysis of key financial ratios. While internal stakeholders like corporate managers
may use financial statement ratios to flag problems requiring attention, they have
access to a far greater range of other financial information than external stakeholders to
make their decisions.
External stakeholders simply have the financial statements covering past periods as
their only source of information to give them insights into the financial position and
performance of the company. So a ratio analysis of the income statement and balance
sheet to calculate the key financial ratios is vitally important to them.
Typical external stakeholders include:
 Existing or potential investors in the company and their share analyst.
 Existing or potential loan providers (bank, finance company) in regard to a
company's creditworthiness.
 existing or potential suppliers providing credit arrangement to the company
(creditors)
Key financial ratio areas

These external stakeholders are most interested in using the financial ratio analysis to
answer questions about 5 key areas of concern:
 The ability of the company to pay its bills as they become due. An analysis of the
Liquidity ratios helps these stakeholders determine the extent to which the company
has the cash necessary to fund its operations and plans.
 The extent to which the company is relying on external debt to fund its operations
and plans. An analysis of the Debt management ratios helps these stakeholders
assess the liquidation risk that excessive debt funding can have on the company's
viability as well as the profit impact of interest rate changes.
 The ability of the management to efficiently and effectively manage the assets
under their control. An analysis of the Asset management ratios helps internal and
external stakeholders identify poor management performance in regards to the
management of assets like inventory, fixed assets and debtors.
 The financial sustainability of a company and its ability to generate sufficient profits
to meet the expected returns of investors. An analysis of the Profitability ratios helps
internal and external stakeholders monitor the selling price policy and provides
comparable return on investment benchmarks against assets employed and equity
invested.
 The attractiveness of the company as an investment option in a competitive market
for capital. An analysis of the Market value ratios helps both internal and external

stakeholders identify the market current perception of the company in regard to
future profit potential.
Notes
To obtain a complete view of the financial position and performance of the business
a stakeholder would need to combine the financial ratio analysis with non-financial
metrics (brand value, management reputation, and PR/Press status) as well as
comparing these ratios with previous years and with industry or competitor benchmarks.
Typical financial ratios analyzed in each area of concern include:
 Liquidity ratios: Current ratio and Acid Test Ratio.
 Debt management ratios: Debt to equity ratio (leverage) and Times interest
earned
 Asset management ratios: Inventory turnover and Average collection period.
 Profitability ratios: Gross profit % of sales, net profit % of sales, Return on Assets
(ROA), Return on Equity (ROE).
 Market value ratios: Price Earnings Ratio (PE) and Dividend Yield.
What each ratio means

 Current ratio: Funders generally look for $2 of assets that can be easily converted
to cash for every $1 of current liability to ensure the company can pays its bills as
they fall due.
 Acid Test Ratio: Having $1 in cash for every $1 in current liability is a further
indication that the company can easily pay its bills when they fall due.
 Debt to equity ratio (leverage): Debt funding of 40% of total assets to equity
funding of 60% is generally considered a manageable level of debt for most
companies. This does vary significantly from industry to industry. The greater the %
of debt, the greater the risk the company is from being liquidated by external
parties.
 Times interest earned: A high number here gives comfort to funders that the
company is easily able to pay the interest bill on their loan funds and can cope with
interest rate increases should they be required in the future. 4-6 times is generally
considered safe.
 Inventory turnover: A lower number than the industry average means you might
be holding too much inventory - a higher than industry average may mean you are
sometimes running out of inventory and not maximizing sales.
 Average collection period: This is an important metric for cash flow management
and is usually monitored against previous periods. If the ratio increases it means
that debtors are paying their debts slower which can impact on your ability to meet
your obligations.
 Gross profit % of sales: Lower than industry average could mean the company is
discounting its prices, there is misappropriation or retail prices are not being
adjusted for increases in cost prices.
 Net profit % of sales: This ratio identified the safety margin that the company has
against negative impacts on its selling prices or costs. This is usually monitored
against previous periods to flag any signs of deterioration in the company's
sustainability.
 Return on Assets (ROA): This ratio looks at the amount of asset investment being
used to produce the profit. The ratio identifies when management are over
capitalizing their business and possibly tying up funds that could be used better
elsewhere.
 Return on Equity (ROE): This widely used ratio indicates the earning power on
shareholder investment and is frequently used in comparing two or more companies
in an industry. The ratio focuses on the returns available to ordinary shareholders.

 Price Earnings Ratio (PE): Identifies the market sentiment concerning the future
profit potential of the company. Greater than 16 PE means the market believes that
Notes profits will increase in the future and less than 16 PE that the market expects profits
to fall from their current position.
 Dividend Yield: Allows investors to compare the cash flow returns from investing in
the company against putting the money into fixed interest investments.
4.2.1 Most significant ratios and their primary measure

Generally, financial ratios are classified on the basis of function or test, on the basis of
financial statements, and on the basis of importance. These three classifications are
briefly discussed below:
Classification of financial ratios on the basis of function

On the basis of function or test, the ratios are classified as liquidity ratios, profitability
ratios, activity ratios and solvency ratios.
Liquidity Ratios
Liquidity ratios measure the adequacy of current and liquid assets and help evaluate the
ability of the business to pay its short-term debts. The ability of a business to pay its
short-term debts is frequently referred to as short-term solvency position or liquidity
position of the business.
Generally a business with sufficient current and liquid assets to pay its current
liabilities as and when they become due is considered to have a strong liquidity position
and a business with insufficient current and liquid assets is considered to have weak
liquidity position.
Short-term creditors like suppliers of goods and commercial banks use liquidity
ratios to know whether the business has adequate current and liquid assets to meet its
current obligations. Financial institutions hesitate to offer short-term loans to businesses
with weak short-term solvency position.
Four commonly used liquidity ratios are given below:
1. Current ratio or working capital ratio
2. Quick ratio or acid test ratio
3. Absolute liquid ratio
4. Current cash debt coverage ratio
Unfortunately, liquidity ratios are not true measure of liquidity because they tell
about the quantity but nothing about the quality of the current assets and, therefore,
should be used carefully. For a useful analysis of liquidity, these ratios are used in
conjunction with activity ratios (also known as current assets movement ratios).
Examples of activity ratios are receivables turnover ratio, accounts payable turnover
ratio and inventory turnover ratio etc.
Profitability ratios
Profit is the primary objective of all businesses. All businesses need a consistent
improvement in profit to survive and prosper. A business that continually suffers losses
cannot survive for a long period.
Profitability ratios measure the efficiency of management in the employment of
business resources to earn profits. These ratios indicate the success or failure of a
business enterprise for a particular period of time.
Profitability ratios are used by almost all the parties connected with the business.
A strong profitability position ensures common stockholders a higher dividend
income and appreciation in the value of the common stock in future.
Creditors, financial institutions and preferred stockholders expect a prompt payment
of interest and fixed dividend income if the business has good profitability position.
Notes
Management needs higher profits to pay dividends and reinvest a portion in the
business to increase the production capacity and strengthen the overall financial
position of the company.
Some important profitability ratios are given below:
 Net profit (NP) ratio
 Gross profit (GP) ratio
 Price earnings ratio (P/E ratio)
 Operating ratio
 Expense ratio
 Dividend yield ratio
 Dividend payout ratio
 Return on capital employed ratio
 Earnings per share (EPS) ratio
 Return on shareholder’s investment/Return on equity
 Return on common stockholders’ equity ratio
Activity ratios
Activity ratios (also known as turnover ratios) measure the efficiency of a firm or
company in generating revenues by converting its production into cash or sales.
Generally a fast conversion increases revenues and profits.
Activity ratios show how frequently the assets are converted into cash or sales and,
therefore, are frequently used in conjunction with liquidity ratios for a deep analysis of
liquidity.
Some important activity ratios are:
 Inventory turnover ratio
 Receivables turnover ratio
 Average collection period
 Accounts payable turnover ratio
 Average payment period
 Asset turnover ratio
 Working capital turnover ratio
 Fixed assets turnover ratio
Solvency ratios
Solvency ratios (also known as long-term solvency ratios) measure the ability of a
business to survive for a long period of time. These ratios are very important for
stockholders and creditors.
Solvency ratios are normally used to:
 Analyze the capital structure of the company
 Evaluate the ability of the company to pay interest on long term borrowings
 Evaluate the ability of the company to repay principal amount of the long term loans
(debentures, bonds, medium and long term loans etc.).
 Evaluate whether the internal equities (stockholders’ funds) and external equities
(creditors’ funds) are in right proportion.

Some frequently used long-term solvency ratios are given below:

Debt to equity ratio
Notes 
 Times interest earned (TIE) ratio
 Proprietary ratio
 Fixed assets to equity ratio
 Current assets to equity ratio
 Capital gearing ratio
Classification on the basis of financial statements
Income statement/profit and loss ratios

Income statement/profit and loss account ratios are those ratios that are calculated by
using the items of income statement/profit and loss account of a particular period only.
Examples of income statement/profit and loss account ratios are net profit ratio, gross
profit ratio, operating ratio, and times interest earned ratio etc.
Balance sheet ratios

Balance sheet ratios are those ratios that are calculated by using figures from the
balance sheet only. The figures must be used from the balance sheet of the same
period. Examples of balance sheet ratios are current ratio, liquid ratio, and debt to
equity ratio etc.
Composite ratios
These ratios are calculated by using the items of both income statement and balance
sheet for the same period. Composite ratios are, therefore, also known as mixed ratios
and inter-statement ratios. Numerous composite ratios are computed depending on the
need of analyst. Some examples are inventory turnover ratio, receivables turnover ratio,
accounts payable turnover ratio, and working capital turnover ratio etc.
Classification on the basis of importance

On the basis of importance or significance, the ratios are classified as primary ratios
and secondary ratios. The most important ratios are called primary ratios and less
important ratios are called secondary ratios. Secondary ratios are usually used to
explain the primary ratios.
Examples of primary ratios for a commercial undertaking are return on capital
employed ratio and net profit ratio because the basic purpose of these undertakings is
to earn profit.
Importance of ratios significantly varies among industries therefore each industry
has its own primary and secondary ratios. A ratio that is of primary importance in one
industry may be of secondary importance in another industry.
Classification of ratios on the basis of importance or significance is very useful for
inter-firm comparisons.
Financial ratios are one of the most common tools of managerial decision making. A
ratio is a comparison of one number to another—mathematically, a simple division
problem. Financial ratios involve the comparison of various figures from the financial
statements in order to gain information about a company's performance. It is the
interpretation, rather than the calculation, that makes financial ratios a useful tool for
business managers. Ratios may serve as indicators, clues, or red flags regarding
noteworthy relationships between variables used to measure the firm's performance in
terms of profitability, asset utilization, liquidity, leverage, or market valuation.

Use and Users of Ratio Analysis
There are basically two uses of financial ratio analysis: to track individual firm Notes
performance over time, and to make comparative judgments regarding firm
performance. Firm performance is evaluated using trend analysis—calculating
individual ratios on a per-period basis, and tracking their values over time. This analysis
can be used to spot trends that may be cause for concern, such as an increasing
average collection period for outstanding receivables or a decline in the firm's liquidity
status. In this role, ratios serve as red flags for troublesome issues, or as benchmarks
for performance measurement.
Another common usage of ratios is to make relative performance comparisons. For
example, comparing a firm's profitability to that of a major competitor or observing how
the firm stacks up versus industry averages enables the user to form judgments
concerning key areas such as profitability or management effectiveness. Users of
financial ratios include parties both internal and external to the firm. External users
include security analysts, current and potential investors, creditors, competitors, and
other industry observers. Internally, managers use ratio analysis to monitor
performance and pinpoint strengths and weaknesses from which specific goals,
objectives, and policy initiatives may be formed.
Profitability Ratios
Perhaps the types of ratios most often used and considered by those outside a firm are
the profitability ratios. Profitability ratios provide measures of profit performance that
serve to evaluate the periodic financial success of a firm. One of the most widely-used
financial ratios is net profit margin, also known as return on sales.
Return on sales provides a measure of bottom-line profitability. For example, a net
profit margin of 6 percent means that for every dollar in sales, the firm generated six
cents in net income.
Two other margin measures are gross profit margin and operating margin.
Gross margin measures the direct production costs of the firm. A gross profit margin
of 30 percent would indicate that for each dollar in sales, the firm spent seventy cents in
direct costs to produce the good or service that the firm sold.
Operating margin goes one step further, incorporating nonproduction costs such as
selling, general, and administrative expenses of the firm. Operating profit is also
commonly referred to as earnings before interest and taxes, or EBIT. An operating
margin of 15 percent would indicate that the firm spent an additional fifteen cents out of
every dollar in sales on nonproduction expenses, such as sales commissions paid to
the firm's sales force or administrative labor expenses.
Two very important measures of the firm's profitability are return on assets and
return on equity.
Return on assets (ROA) measures how effectively the firm's assets are used to
generate profits net of expenses. An ROA of 7 percent would mean that for each dollar
in assets, the firm generated seven cents in profits. This is an extremely useful measure
of comparison among firms' competitive performance, for it is the job of managers to
utilize the assets of the firm to produce profits.
Return on equity (ROE) measures the net return per dollar invested in the firm by
the owners, the common shareholders. An ROE of 11 percent means the firm is
generating an 11-cent return per dollar of net worth.
One should note that in each of the profitability ratios mentioned above, the
numerator in the ratio comes from the firm's income statement. Hence, these are
measures of periodic performance, covering the specific period reported in the firm's
income statement. Therefore, the proper interpretation for a profitability ratio such as an

ROA of 11 percent would be that, over the specific period (such as fiscal year 2004),
the firm returned eleven cents on each dollar of asset investment.
Notes
Asset Utilization Ratios
Asset utilization ratios provide measures of management effectiveness. These ratios
serve as a guide to critical factors concerning the use of the firm's assets, inventory,
and accounts receivable collections in day-to-day operations. Asset utilization ratios are
especially important for internal monitoring concerning performance over multiple
periods, serving as warning signals or benchmarks from which meaningful conclusions
may be reached on operational issues. An example is the total asset turnover (TAT)
ratio.
This ratio offers managers a measure of how well the firm is utilizing its assets in
order to generate sales revenue. An increasing TAT would be an indication that the firm
is using its assets more productively. For example, if the TAT for 2003 was 2.2×, and for
2004 3×, the interpretation would follow that in 2004, the firm generated $3 in sales for
each dollar of assets, an additional 80 cents in sales per dollar of asset investment over
the previous year. Such change may be an indication of increased managerial
effectiveness.
A similar measure is the fixed asset turnover (FAT) ratio.
Fixed assets (such as plant and equipment) are often more closely associated with
direct production than are current assets (such as cash and accounts receivable), so
many analysts prefer this measure of effectiveness. A FAT of 1.6× would be interpreted
as the firm generated $1.60 in sales for every $1 it had in fixed assets.
Two other asset utilization ratios concern the effectiveness of management of the
firm's current assets. Inventory is an important economic variable for management to
monitor since dollars invested in inventory have not yet resulted in any return to the
firm. Inventory is an investment, and it is important for the firm to strive to maximize
its inventory turnover. The inventory turnover ratio is used to measure this aspect of
performance.
Cost of goods sold (COGS) derives from the income statement and indicates the
expense dollars attributed to the actual production of goods sold during a specified
period. Inventory is a current asset on the balance sheet. Because the balance sheet
represents the firm's assets and liabilities at one point in time, an average figure is often
used from two successive balance sheets. Managers attempt to increase this ratio,
since a higher turnover ratio indicates that the firm is going through its inventory more
often due to higher sales. A turnover ratio of 4.75×, or 475 percent, means the firm sold
and replaced its inventory stock more than four and one-half times during the period
measured on the income statement.
One of the most critical ratios that management must monitor is days sales
outstanding (DSO), also known as average collection period.
This represents a prime example of the use of a ratio as an internal monitoring tool.
Managers strive to minimize the firm's average collection period, since dollars received
from customers become immediately available for reinvestment. Periodic measurement
of the DSO will "red flag" a lengthening of the firm's time to collect outstanding accounts
before customers get used to taking longer to pay. A DSO of thirty-six means that, on
average, it takes thirty-six days to collect on the firm's outstanding accounts. This is an
especially critical measure for firms in industries where extensive trade credit is offered,
but any company that extends credit on sales should be aware of the DSO on a regular
basis.
Leverage Ratios
Leverage ratios, also known as capitalization ratios, provide measures of the firm's use
of debt financing. These are extremely important for potential creditors, who are
concerned with the firm's ability to generate the cash flow necessary to make interest
payments on outstanding debt. Thus, these ratios are used extensively by analysts
outside the firm to make decisions concerning the provision of new credit or the
extension of existing credit arrangements. It is also important for management to Notes
monitor the firm's use of debt financing. The commitment to service outstanding debt is
a fixed cost to a firm, resulting in decreased flexibility and higher break-even production
rates. Therefore, the use of debt financing increases the risk associated with the firm.
Managers and creditors must constantly monitor the trade-off between the additional
risk that comes with borrowing money and the increased opportunities that the new
capital provides. Leverage ratios provide a means of such monitoring.
Perhaps the most straightforward measure of a firm's use of debt financing is the
total-debt ratio.
It is important to recall that there are only two ways to finance the acquisition of any
asset: debt (using borrowed funds) and equity (using funds from internal operations or
selling stock in the company). The total debt ratio captures this idea. A debt ratio of 35
percent means that, for every dollar of assets the firm has, 35 cents was financed with
borrowed money. The natural corollary is that the other 65 cents came from equity
financing. This is known as the firm's capital structure—35 percent debt and 65 percent
equity. Greater debt means greater leverage, and more leverage means more risk. How
much debt is too much is a highly subjective question, and one that managers
constantly attempt to answer? The answer depends, to a large extent, on the nature of
the business or industry. Large manufacturers, who require heavy investment in fixed
plant and equipment, will require higher levels of debt financing than will service firms
such as insurance or advertising agencies.
The total debt of a firm consists of both long- and short-term liabilities. Short-term
(or current) liabilities are often a necessary part of daily operations and may fluctuate
regularly depending on factors such as seasonal sales. Many creditors prefer to focus
their attention on the firm's use of long-term debt. Thus, a common variation on the total
debt ratio is the long-term debt ratio, which does not incorporate current liabilities in the
numerator.
In a similar vein, many analysts prefer a direct comparison of the firm's capital
structure. Such a measure is provided by the debt-to-equity ratio.
This is perhaps one of the most misunderstood financial ratios, as many confuse it
with the total debt ratio. A debt-to-equity ratio of 45 percent would mean that for each
dollar of equity financing, the firm has 45 cents in debt financing. This does not mean
that the firm has 45 percent of its total financing as debt; debt and equity percentages,
together, must sum to one (100 percent of the firm's total financing). A little algebra will
illustrate this point. Let x = the percent of equity financing (in decimal form), so 0.45 x is
the percent of debt financing. Then x + 0.45 x = 1, and x = 0.69. So, a debt to equity
ratio of 45 percent indicates that each dollar of the firm's assets are financed with 69
cents of equity and 31 cents with debt. The point here is to caution against confusing
the interpretation of the debt-to-equity ratio with that of the total debt ratio.
Two other leverage ratios that are particularly important to the firm's creditors are
the times-interest-earned and the fixed-charge coverage ratios. These measure the
firm's ability to meet its on-going commitment to service debt previously borrowed. The
times-interest-earned (TIE) ratio, also known as the EBIT coverage ratio, provides a
measure of the firm's ability to meet its interest expenses with operating profits.
For example, a TIE of 3.6× indicates that the firm's operating profits from a recent
period exceeded the total interest expenses it was required to pay by 360 percent. The
higher this ratio, the more financially stable the firm and the greater the safety margin in
the case of fluctuations in sales and operating expenses. This ratio is particularly
important for lenders of short-term debt to the firm, since short-term debt is usually paid
out of current operating revenue.
Similarly, the fixed charge coverage ratio, also known as the debt service coverage
ratio, takes into account all regular periodic obligations of the firm.

The adjustment to the principal repayment reflects the fact that this portion of the
debt repayment is not tax deductible. By including the payment of both principal and
Notes interest, the fixed charge coverage ratio provides a more conservative measure of the
firm's ability to meet fixed obligations.
Liquidity Ratios
Managers and creditors must closely monitor the firm's ability to meet short-term
obligations. The liquidity ratios are measures that indicate a firm's ability to repay short-
term debt. Current liabilities represent obligations that are typically due in one year or
less. The current and quick ratios are used to gauge a firm's liquidity.
A current ratio of 1.5× indicates that for every dollar in current liabilities, the firm has
$1.50 in current assets. Such assets could, theoretically, be sold and the proceeds used
to satisfy the liabilities if the firm ran short of cash. However, some current assets are
more liquid than others. Obviously, the most liquid current asset is cash. Accounts
receivable are usually collected within one to three months, but this varies by firm and
industry. The least liquid of current assets is often inventory. Depending on the type of
industry or product, some inventory has no ready market. Since the economic definition
of liquidity is the ability to turn an asset into cash at or near fair market value, inventory
that is not easily sold will not be helpful in meeting short-term obligations. The quick (or
acid test) ratio incorporates this concern.
By excluding inventories, the quick ratio is a more strident liquidity measure than
the current ratio. It is a more appropriate measure for industries that involve long
product production cycles, such as in manufacturing.
Market Value Ratios

Managers and investors are interested in market ratios, which are used in valuing the
firm's stock. The price-earnings ratio and the market-to-book value ratio are often used
in valuation analysis. The price/earnings ratio, universally known as the PE ratio, is one
of the most heavily-quoted statistics concerning a firm's common stock. It is reported in
the financial pages of newspapers, along with the current value of the firm's stock price.
A note of caution is warranted concerning the calculation of PE ratios. Analysts use
two different components in the denominator: trailing earnings and forecast earnings.
Trailing earnings refer to the firm's reported earnings, per share, over the last twelve
months of operation. Forecast earnings are based on security analyst forecasts of what
they expect the firm to earn in the coming twelve-month period. Neither definition is
more correct than the other; one should simply pay attention to which measure is used
when consulting published PE ratios. A PE ratio of sixteen can be interpreted as
investors are willing to pay $16 for $1 worth of earnings. PE ratios are used extensively,
on a comparative basis, to analyze investment alternatives. In investment lingo, the PE
ratio is often referred to as the firm's "multiple." A high PE is often indicative of
investors’ belief that the firm has very promising growth prospects, while firms in more
mature industries often trade at lower multiples.
A related measure used for valuation purposes is the market-to-book value ratio.
The book value of a firm is defined as:
Technically, the book value represents the value of the firm if all the assets were
sold off, and the proceeds used to retire all outstanding debt. The remainder would
represent the equity that would be divided, proportionally, among the firm's
shareholders. Many investors like to compare the current price of the firm's common
stock with its book, or break-up, value.
This is also known as the price/book ratio. If the ratio is greater than one, which is
often the case, then the firm is trading at a premium to book value. Many investors
regard a market-to-book ratio of less than one an indication of an undervalued firm.
While the interpretation one draws from market ratios is highly subjective (do high PE or

low PE firms make better investments?), these measures provide information that is
valued both by managers and investors regarding the market price of a firm's stock.
Notes
Cautions on the use and Interpretation of Financial Ratios
Financial ratios represent tools for insight into the performance, efficiency, and
profitability of a firm. Two noteworthy issues on this subject involve ratio calculation and
interpretation. For example, if someone refers to a firm's "profit margin" of 18 percent,
are they referring to gross profit margin, operating margin, or net profit margin?
Similarly, is a quotation of a "debt ratio" a reference to the total debt ratio, the long-term
debt ratio, or the debt-to-equity ratio? These types of confusions can make the use of
ratio analysis a frustrating experience.
Interpreting financial ratios should also be undertaken with care. A net profit margin
of 12 percent may be outstanding for one type of industry and mediocre to poor for
another. This highlights the fact that individual ratios should not be interpreted in
isolation. Trend analyses should include a series of identical calculations, such as
following the current ratio on a quarterly basis for two consecutive years. Ratios used
for performance evaluation should always be compared to some benchmark, either an
industry average or perhaps the identical ratio for the industry leader.
Another factor in ratio interpretation is for users to identify whether individual
components, such as net income or current assets, originate from the firm's income
statement or balance sheet. The income statement reports performance over a
specified period of time, while the balance sheet gives static measurement at a single
point in time. These issues should be recognized when one attempts to interpret the
results of ratio calculations.
Despite these issues, financial ratios remain useful tools for both internal and
external evaluations of key aspects of a firm's performance. A working knowledge and
ability to use and interpret ratios remains a fundamental aspect of effective financial
management. The value of financial ratios to investors became even more apparent
during the stock market decline of 2000, when the bottom dropped out of the soaring
"dot.com" economy. Throughout the long run-up, some financial analysts warned that
the stock prices of many technology companies—particularly Internet start-up
businesses—were overvalued based on the traditional rules of ratio analysis. Yet
investors largely ignored such warnings and continued to flock to these companies in
hopes of making a quick return. In the end, however, it became clear that the old rules
still applied, and that financial ratios remained an important means of measuring,
comparing, and predicting firm performance.
4.2.2 Key financial ratios included as Corporate Objectives

As a business owner or the manager of a business you might want to develop a reward
based system that would incentivize employees to be more efficient and simultaneously
give them a quantifiable goal and purpose to achieve. Where would you begin your
assessments of performance and how would you take and record these
measurements? Hypothetically say that you ran a business and your current liabilities
were skyrocketing. How would you know if you are keeping up with them? How would
you determine or measure your likelihood of the business to be able to pay its current
liabilities? This is where financial analysis and financial ratio analysis become extremely
useful to business managers as well as employees.
The term financial analysis refers to collecting the financial data for a business, and
then making comparisons amongst different variables in either the same financial
statement, across multiple financial statements, or across the business as a whole.
Financial ratios allow business managers and investors to establish logical
mathematical relationships between different variables (items) that are listed in the
financial statements. The main source of financial information for a business will be the
four primary financial statements, which are the balance sheet, the income statement,
the statement of stockholders' equity, and the statement of cash flows. The footnotes

that the management team has included in their financial reports can also serve as a
valuable source of qualitative information that helps to understand the thought process
Notes of the business owners or management team, as well as the future strategic direction
for the business.
There are some businesses that are required by law to file and disclose additional
information, such as the information provided in the footnotes. These requirements are
generally applied to publicly traded companies. Publicly traded companies are
businesses that have made their stock available for purchase to the public. The
companies are registered with the United States Securities and Exchange Commission
(SEC) and are subject to complying with the guidelines and the financial securities laws
of the United States.
When performing financial analysis for a business it is important to examine and
take into account other sources of data in addition to the financial statements for the
business. The other sources of data that could potentially affect the specific business,
the industry or sector specifically, or the economy as a whole will play a substantial role
in understand a high-level macro overview of the current condition of a business, the
trends that it is currently exhibiting, and the future direction for the business. An
example of this type of data would be the United States Consumer Price Index (CPI),
which is a measurement of the changes to prices of consumer and household goods.
Another example would be the Gross Domestic Product, which is collective financial
value of the cumulative finished goods and services within the United States over a
yearly timeframe. Additionally other economic metrics such as consumer prices,
producer prices, and household spending will all have an effect on the financial state of
a company and an impact on the future trends and direction of the company.
Financial ratios express relationships between financial statement items. Although
they provide historical data, management can use ratios to identify internal strengths
and weaknesses, and estimate future financial performance. Investors can use ratios to
compare companies in the same industry. Ratios are not generally meaningful as
standalone numbers, but they are meaningful when compared to historical data and
industry averages.
Liquidity
The most common liquidity ratio is the current ratio, which is the ratio of current assets
to current liabilities. This ratio indicates a company's ability to pay its short-term bills. A
ratio of greater than one is usually a minimum because anything less than one means
the company has more liabilities than assets. A high ratio indicates more of a safety
cushion, which increases flexibility because some of the inventory items and receivable
balances may not be easily convertible to cash. Companies can improve the current
ratio by paying down debt, converting short-term debt into long-term debt, collecting its
receivables faster and buying inventory only when necessary.
Solvency
Solvency ratios indicate financial stability because they measure a company's debt
relative to its assets and equity. A company with too much debt may not have the
flexibility to manage its cash flow if interest rates rise or if business conditions
deteriorate. The common solvency ratios are debt-to-asset and debt-to-equity. The
debt-to-asset ratio is the ratio of total debt to total assets. The debt-to-equity ratio is the
ratio of total debt to shareholders' equity, which is the difference between total assets
and total liabilities.
Profitability
Profitability ratios indicate management's ability to convert sales dollars into profits and
cash flow. The common ratios are gross margin, operating margin and net income
margin. The gross margin is the ratio of gross profits to sales. The gross profit is equal
to sales minus cost of goods sold. The operating margin is the ratio of operating profits
to sales and net income margin is the ratio of net income to sales. The operating profit
is equal to the gross profit minus operating expenses, while the net income is equal to
the operating profit minus interest and taxes. The return-on-asset ratio, which is the
ratio of net income to total assets, measures a company's effectiveness in deploying its Notes
assets to generate profits. The return-on-investment ratio, which is the ratio of net
income to shareholders' equity, indicates a company's ability to generate a return for its
owners.
Efficiency
Two common efficiency ratios are inventory turnover and receivables turnover.
Inventory turnover is the ratio of cost of goods sold to inventory. A high inventory
turnover ratio means that the company is successful in converting its inventory into
sales. The receivables turnover ratio is the ratio of credit sales to accounts receivable,
which tracks outstanding credit sales. A high accounts receivable turnover means that
the company is successful in collecting its outstanding credit balances.
4.2.3 Financial Ratios used in Annual Reports

Financial ratios are mathematical comparisons of financial statement accounts or
categories. These relationships between the financial statement accounts help
investors, creditors, and internal company management understand how well a
business is performing and areas of needing improvement.
Financial ratios are the most common and widespread tools used to analyze a
business' financial standing. Ratios are easy to understand and simple to compute.
They can also be used to compare different companies in different industries. Since a
ratio is simply a mathematically comparison based on proportions, big and small
companies can be use ratios to compare their financial information. In a sense, financial
ratios don't take into consideration the size of a company or the industry. Ratios are just
a raw computation of financial position and performance.
Ratios allow us to compare companies across industries, big and small, to identify
their strengths and weaknesses. Financial ratios are often divided up into seven main
categories: liquidity, solvency, efficiency, profitability, market prospect, investment
leverage, and coverage.
One of the easiest ways of analyzing an annual report is through the use of
mathematical ratios. Ratios between line items are compared to "industry standards," or
to ratios of similar companies, to find out whether the company being analyzed is better
than, worse than, or in the middle of the pack.
There are four basic attributes that are commonly analyzed using financial ratios.
They are "liquidity," "leverage," "turnover," and "profitability." Used together, you can get
a pretty good idea of the health of a firm, relative to the industry it is in.
Liquidity
Liquidity ratios are used to determine the company's ability to pay its bills from day to
day. By calculating these ratios, we get a good idea of the basic functionality of the firm-
-if they owe $4 million next week, and they've only got $20 in the bank and no more
money coming in, it really doesn't matter how good the company's prospects are in the
long term: They're not going to last past next week.
Two of the most commonly used liquidity ratios are the "Current Ratio" and the
"Quick Ratio." The Current Ratio is calculated by dividing current assets by current
liabilities. Remember that "current assets" are assets that are cash or will be converted
into cash in the next 12 months. Current liabilities are amounts owed in the next 12
months. So if the Current Asset: Current Liability ratio is less than 1, chances are, the
company isn't doing very well--they can't pay back all the money they owe with the cash
they'll have on hand and will have to start selling long-term assets, or look at refinancing
the company, in order to pay their short-term bills. Doing this ratio for Alta Genetics
gives us 2.1--so the current assets are two times the current liabilities.

The second liquidity ratio is the Quick Ratio. It's just like the current ratio, but
inventory stores aren't counted as a current asset. Sometimes, inventories build up on
Notes statements and are worthless or very hard to get rid of in real life--if you had $400,000
worth of 1980s computers, they'd be kind of hard to get rid of at the retail value.
Because of the unreliability of inventory values, a lot of people use a Quick Ratio
instead of a Current Ratio to determine liquidity. Remember that even though this
number will always be lower than the Current Ratio, it doesn't mean the company is
doing worse, because you're comparing this company's Quick Ratio to the industry
average Quick Ratio, and every other company's number will have been calculated
without inventory as well.
Alta Genetics has a quick ratio of 1.2, so if inventories aren't counted, their current
assets are just barely covering their current liabilities.
Leverage
Leverage is a term used to describe the company's current ability to pay its long-term
debt. For example, if you were to start a small bioinformatics company, you could do it
one of two ways: You could start with your own computer, phone, and a couple of other
things you (or another investor) purchased. Or you could get a small business loan for
all your equipment, software, and other stuff and worry about paying monthly payments
as business comes in. In the first example, you have 0 debt. Not just 0 debt owed this
year, but 0 debt, and are therefore not leveraged at all. In the second example, a whole
bunch of your business is run off of a loan and 50% of your company is debt, which
means, basically, that if the company does poorly, it'll do poorly much faster (because it
has to pay interest every month, etc.). If the company does well, it'll do much better for
the investors (because you've invested less money into the company to start with).
Generally, the more leverage a company has, the more "upside potential" and
"downside potential" the company has for investors.
Two of the most commonly used ratios for evaluating leverage are the Debt Ratio
and the Times Interest Earned ratio.
The debt ratio simply takes the total assets less the total equity (basically, the total
debt), and divides it by the total assets. The ratio gives a percentage of the company
that is financed by debt. For example, a company using 28% debt will be said to be
more leveraged than a company using 10% debt in its capital structure. Alta Genetics'
debt ratio is 64%.
The Times Interest Earned ratio compares the amount of interest that is owed every
year to the amount of money earned before interest and tax. By dividing Earnings
(before interest and tax) by the interest paid that year, an analyst can get a good idea of
what percentage of the company's earnings is being used to finance debt. If you're only
making $100, but owe $110 a year in interest, you're not doing nearly as well as if you
only owed $10 a year in interest. By seeing how much earnings are going back to the
company and how much are going to the creditors, you can get a pretty good idea of
how leveraged the company is. For Alta Genetics, the Times Interest Earned ratio is
1.32, so a good deal of the money earned this year is going straight to the interest
expense [a fact that is very much consistent with the high (64%) debt the company is
carrying].
Turnover Ratios
Turnover ratios calculate the approximate "utilization" of assets. They give you a look
into how well the company is managing things like its inventory levels, the accounts
receivable on its books, and the like.
There are three very commonly used turnover ratios. They're all really the same
calculation but for different items on the balance sheet.

Inventory Turnover
By dividing the "cost of goods sold" line item by the inventory line item, you get what's Notes
known as an inventory multiple. For example, if you've got $50 worth of stuff in
inventory, and your cost of goods sold (essentially your costs of inventory for the year)
was $500, you get an inventory multiple of 10 times. This means that, every year, you
"turn over" your inventory 10 times. By dividing the number of days in the year by this
number, you get the number of days the average piece of inventory sits on the shelf: In
our example above, 365/10 = 36, so the average piece of inventory stays on the shelf a
little longer than a month.
Inventory turnover is key in high-tech industries, where inventory becomes obsolete
very quickly. It also gives a bit of an indication as to the competency of management: If
they're making too much or too little stuff, they're probably not running their company
properly.
In the case of Alta Genetics, their product is not quite as high-tech and probably has
a long shelf life, so their inventory turnover of 267 days isn't quite as high as it appears.
Receivables Turnover
Receivables turnover does the exact same thing as inventory turnover but looks at the
Accounts Receivable line item. Remember, this line item indicates the amount of money
your clients owe you for stuff they've bought but not paid for yet.
By dividing sales by accounts receivable, you get a multiple just like the one in
inventory turnover. By dividing the number of days in the year by this number, you get
an idea of how long your average receivable lasts. For example, if your sales were $500
for the year, and you had accounts receivable of $50, your average accounts receivable
age would be 365/ (500/50), or 36.5 days. This means that the average customer only
pays you back 36.5 days after they've purchased the item.
Although receivables turnover, like all of these ratios, is highly dependent on the
industry you are in (a good ratio for the biotech industry may be an awful ratio for
General Motors, and vice versa), you can still get an idea of what's going on in the
company by using it. It gives you an idea of how reliable your customers are with
payments and how good the management team is--if they're forgetting to get paid by
their clients ("letting receivables slide"), they're not doing a good job.
The average age of accounts receivable at Alta Genetics is just over 90 days.
Although this seems high at first glance, it may not be that high for the industry they're
in and would have to be compared to other companies in this specific field.
Payables Turnover
Payables turnover is a measure of how long the company is waiting before paying off
the people that it owes, so it's the complete opposite of receivables turnover. Calculated
the same way, it gives the average length of time before the company is paying its bills.
If this is too short, the company may be missing a really good opportunity for financing
(because postponement of paying for stuff you buy is, in effect, financing--just ask any
student). If it's too long, it's usually a sign of trouble. You don't want to make your
suppliers mad: If they cut off the supply, you can't make any money.
In the case of Alta Genetics, it's impossible to determine the age of their payables
due to the amalgamation of payables and "accrued liabilities" as one line on their
balance sheet. If the number given on this line were just accounts payable, the average
time before a bill is paid would be over 6 months!
Profitability Ratios
Profitability ratios ask one easy question: Is the company making money? There are all
sorts of different ratios to look at this. We're going to be discussing three of the most
common--profit margin, return on assets, and return on equity.

Profit Margin
Notes Profit margin asks one simple question: Of all the stuff you sold that year, what
percentage was pure profit? We calculate profit margin by dividing net income (the
bottom line--after all expenses, etc., the amount of money retained by the company
through sales that year) by sales (the amount of stuff sold). For example, if your net
income at the end of the year, after all your expenses, taxes, and such, was $30, and
you sold $300 worth of stuff this year, your profit margin would be 10%. Profit margin is
useful for measuring a whole variety of things. First, if you can figure out your
competitions' profit margin, then you've got a pretty good idea of whether they're making
more or less money than you for selling the same amount of stuff. That is, if your
competition has a profit margin of 30% and you've only got 10%, it's going to be very
hard for you to compete: If your competition wants you out of the market, they could just
lower their price by 20%, giving them a profit margin of 10% (still profitable) and making
yours -10% and driving you to bankruptcy.
Profit margin is also a useful tool when a firm is growing rapidly. As your sales go
up, what happens to your expenses? If your profit margin is shrinking as you're growing,
you may be becoming less efficient.
Alta Genetics, like many biotech start-ups, is unfortunately currently suffering from a
negative profit margin. However, the profit margin has been improving: down to -1%
from -6.5% in 1996. Thus the company is at least moving in the right direction.
Return on Assets
Return on Assets (ROA) gives an idea of how much money you're making, given the
size of the company. The easiest way of figuring this out is by dividing net income by
the total assets of the company. If your Return on Assets is less than the interest rate,
you'd be better off selling all your stuff and putting the cash in the bank, unless you felt it
was going to improve significantly, soon.
Because Alta Genetics posted a loss last year, the return on assets is also going to
be negative. However, this is normal with a small biotech firm: People are willing to
accept a negative ROA in the first few years, in exchange for a high upside potential in
the years to come.
Return on Equity
Return on Equity gives an idea of how much the firm is making per dollar invested in it
by shareholders. The easiest way of calculating it is by dividing net income by total
equity. If shareholders can make a higher return on equity elsewhere, you may be in
trouble: They may decide that some other company is a better investment for them and
pull out their funds.
Again, the Return on Equity is negative in the case of Alta Genetics--theoretically,
you'd be making more money if you put your savings in the bank. However, the
investors are likely in it for the long haul, hoping that when the company starts making
money, it'll make lots.
General Discussion of Income Statement

The income statement has some limitations since it reflects accounting principles. For
example, a company's depreciation expense is based on the cost of the assets it has
acquired and is using in its business. The resulting depreciation expense may not be a
good indicator of the economic value of the asset being used up. To illustrate this point
let's assume that a company's buildings and equipment have been fully depreciated and
therefore there will be no depreciation expense for those buildings and equipment on its
income statement. Is zero expense a good indicator of the cost of using those buildings
and equipment? Compare that situation to a company with new buildings and
equipment where there will be large amounts of depreciation expense.

The remainder of our explanation of financial ratios and financial statement analysis
will use information from the following income statement:
Notes
Common-Size Income Statement

Financial statement analysis includes a technique known as vertical analysis. Vertical
analysis results in common-size financial statements. A common-size income statement
presents all of the income statement amounts as a percentage of net sales. Below is
Example Corporation's common-size income statement after each item from the income
statement above was divided by the net sales of $500,000:

The percentages shown for Example Corporation can be compared to other

companies and to the industry averages. Industry averages can be obtained from trade
Notes associations, bankers, and library reference desks. If a company competes with a
company whose stock is publicly traded, another source of information is that
company's "Management's Discussion and Analysis of Financial Condition and Results
of Operations" contained in its annual report to the Securities and Exchange
Commission (SEC). This annual report is the SEC Form 10-K and is usually accessible
under the "Investor Relations" tab on the corporation's website.
Financial Ratios Based on the Income Statement
4.3 Related Debt Paying Ability & Long-term Debt-paying Ability

If you want to apply for a mortgage loan, finance the purchase of a car or take out any
other long-term loan, your lender will want to know if you are financially secure enough
to pay back its money on time. One way lenders determine this is by looking at a pair of

key long-term ratios that help them decide whether your income is strong enough and
your debts low enough so a loan won't throw you into a financial tailspin.
Notes
Debt-to-Income Ratios
The two main long-term debt-paying ratios that lenders use are both known as debt-to-
income ratios. They compare your monthly debts with your gross monthly income, or
your income before taxes are removed. Monthly debts include every bill you shell out
cash for each month, including car loans, student loans, mortgages and the required
minimum payments on your credit cards. Lenders will add the estimated monthly
payment for the new loan to this total. Your monthly income isn't just your salary.
Lenders also include monthly rent payments, royalties and other payments you receive
each month.
Front-End Ratio
Your front-end ratio compares your gross monthly income with your total monthly
housing debt. Housing debt includes the principal you pay on your mortgage each
month as well as the interest, taxes and insurance that go with this payment. Lenders
typically want your monthly housing costs eating up no more than 28 percent of your
gross monthly income.
Back-End Ratio
Your back-end debt-to-income ratio takes a more holistic approach to your finances. It
looks at the relationship between your gross monthly income and all of your monthly
debts, not just those tied to housing. Lenders prefer that your monthly debts take up no
more than 36 percent of your monthly income.
Example
Let's say your total housing payment, including the principal, interest, taxes and
insurance, is $2,400 a month and your total gross monthly income is $11,666. Your
front-end debt-to-income ratio will be about 21 percent -- your housing debt divided by
your monthly income. If you have another $1,500 in recurring monthly debt, for a total
monthly debt of $3,900, your back-end debt-to-income ratio is about 33 percent -- your
total monthly debt divided by your monthly income.
For a firm being financially sustainable means being able to carry its debt. Usually,
the debt ratio analysis is being applied to a company by potential creditors to see, how
creditworthy it is and analyze its willingness and ability to pay the debt. Generally,
greater amount of company’s debt means greater financial risk of its bankruptcy. Long-
term debt paying ability of a firm can be viewed as indicated by the income statement
and by the balance sheet.
Debt ratio calculation and analysis
Times Interest Earned

The indicator of the firm’s long-term debt paying ability from the income statement view
is the times interest earned ratio. Having normal times interest earned ratio means
lesser risk for a firm not to meet its interest obligation. If this ratio is being relatively high
and stable over the years, a company is financially sustainable, while relatively low and
fluctuating ratio would mean potential problems with paying the long-term obligations.
Times Interest Earned = Recurring Earnings, Excluding Interest Expense, Tax
Expense, Equity Earnings, and Non-controlling Interest ÷ Interest Expense, Including
Capitalized Interest
As seen from the formula, times interest earned ratio measures the amount of
income that can be used to cover interest expenses in the future. In opposition to
percentage, this ratio is expressed in numbers, and it measures how many times a firm
could cover the interest expense with its income, so larger ratios are considered more
desirable than smaller ones. Another formula for times interest earned calculation is as
follows:
Notes
Times Interest Earned = EBIT ÷ Interest Expense
Earnings before Interest and Taxes (EBIT) is also referred as operating profit, and it
measures firm's profit that excludes interest and income tax expenses. Considering this,
times interest earned ratio can also be calculated as follows:
Times Interest Earned = Operating profit ÷ Interest expense
Debt Ratio
The debt ratio is an indicator of firm’s long-term debt-paying ability. It is a ratio of firm’s
total liabilities to its total assets. Use the following formula to calculate the debt ratio:
Debt Ratio = (Total Liabilities ÷ Total Assets) = (Total Assets - Total Equity) ÷ Total
Assets
The debt ratio shows how well creditors are protected in case of company’s
insolvency by indicating the percentage of firm’s assets financed by creditors. Issuing
the additional long-term debt is inappropriate for a company if it’s already existing
creditors are not well protected. In terms of financial sustainability of a business lower
ratios are more favorable. Another ratio that allows to measure firm’s long-term debt
paying ability is long-term debt ratio:
Long-Term Debt Ratio = Long-Term Debt ÷ Total Assets
As seen from the formula, this ratio measures the percentage of a company’s total
assets financed with long-term debt, including loans and financial obligations that last
more than one year. This ratio comparison made for different periods of time would
show whether a company is becoming more or less dependent on debt to run a
business.
The Long-Term Debt to Total Capitalization Ratio

The long-term debt to total capitalization ratio is a ratio showing the financial leverage of
a firm by dividing the long-term debt by the amount of capital available:
The Long-Term Debt to Total Capitalization Ratio = Long-Term Debt ÷ (Long-Term
Debt + Preferred Equity + Common Equity)
This ratio is fully comparable between different companies, and that's why it is
useful for investors, who can measure their risks with different firms by comparing their
long-term debt to total capitalization ratios and identifying the amount of financial
leverage, utilized by these firms. The decrease of the long-term debt to total
capitalization ratio over time would indicate the lessening long-term debt load of the
company as compared to the total capitalization, leaving a larger percentage of the total
capitalization to the total stockholder’s equity, and vice versa.
Debt to Equity Ratio

Another ratio helping the creditors understand how well they are protected in case of
firm’s insolvency is the debt to equity ratio. It’s a ratio that compares the total debt with
the total shareholders’ equity:
Debt to Equity Ratio = Total Liabilities ÷ Shareholders’ Equity
If a company’s debt to equity ratio is high, it has been financing its growth with debt.
This is being done to generate more earnings than it would have been without this
outside financing. In terms of long-term debt-paying ability the lower this ratio is, the
better. Normal values for the debt to equity ratio are different for different industries.
Close to this indicator is long-term debt to equity, comparing only long-term debt with
the stockholders’ equity:

Long-Term Debt to Equity = the Long-Term Debt ÷ (Preferred Equity + Common
Equity)
Notes
The higher the long-term debt to equity ratio is, the greater a company’s leverage is.
Most commonly higher long-term debt to equity ratio of a firm would mean more risk for
the investor.
Debt to Tangible Net worth Ratio

More conservative measure for a firm’s long-term debt-paying ability is debt to tangible
net worth ratio. It indicates creditors’ protection level in case of firm’s insolvency by
comparing its total liabilities with shareholders’ equity excluding intangible assets, such
as trademarks, patents, copyrights, etc.:
Debt to Tangible Net Worth Ratio = Total Liabilities ÷ (Shareholders’ Equity -
Intangible Assets)
Debt to tangible net worth ratio is a measure of the physical worth of a firm, not
including any value derived from intangible assets. As with the debt ratio and the debt to
equity ratio, from the perspective of long-term debt-paying ability having lower ratio is
preferable for a firm.
In addition to the profitability of the firm, applying the debt ratio analysis to it is a
good way for an investor to estimate firm’s performance and measure the risk.
Calculation of debt ratios would clarify the ability of a firm to carry its debt in the long
run. Debt ratio analysis includes calculation of the following ratios:
Times Interest Earned = Recurring Earnings, Excluding Interest Expense, Tax
Expense, Equity Earnings, and Non-controlling Interest ÷ Interest Expense, Including
Capitalized Interest
Debt Ratio = (Total Liabilities ÷ Total Assets) = (Total Assets - Total Equity) ÷ Total
Assets
Long-Term Debt Ratio = Long-Term Debt ÷ Total Assets
The Long-Term Debt to Total Capitalization Ratio = Long-Term Debt ÷ (Long-Term
Debt + Preferred Equity + Common Equity)
Debt to Equity Ratio = Total Liabilities ÷ Shareholders’ Equity
Debt to Tangible Net Worth Ratio = Total Liabilities ÷ (Shareholders’ Equity -
Intangible Assets)
4.3.1 Current Assets

Current assets are balance sheet accounts that represent the value of all assets that
can reasonably expect to be converted into cash within one year. Current assets
include cash and cash equivalents, accounts receivable, inventory, marketable
securities, prepaid expenses and other liquid assets that can be readily converted to
cash.
In the United Kingdom, current assets are also known as current accounts.
BREAKING DOWN 'Current Assets'

Current assets are important to businesses because they can be used to fund day-to-
day operations and pay ongoing expenses. Depending on the nature of the business,
current assets can range from barrels of crude oil, to baked goods, to foreign currency.
On a balance sheet, current assets will normally be displayed in order of liquidity, or the
ease with which they can be turned into cash.
Assets that cannot feasibly be turned into cash in the space of a year – or a
business' operating cycle, if it is longer – are not included in this category and are
instead considered "long-term assets." These also depend on the nature of the

business, but generally include land, facilities, equipment, copyrights and other illiquid
investments.
Notes
Accounts receivable, bills to customers that have yet to be paid, are considered
current assets as long as they can be expected to be paid within a year. If a business
has been making sales by offering loose credit terms, a chunk of its accounts
receivables might not come due for a longer period of time. It is also possible that some
accounts will never be paid in full. This consideration is reflected in an allowance for
doubtful accounts, which is subtracted from accounts receivable. If an account is never
collected, it is written down as a bad debt expense.
Inventory is included as current assets, but this item should be taken with a grain of
salt. Different accounting methods can be used to inflate inventory, and in any case it is
not nearly as liquid as other current assets. It may not even be as liquid as accounts
receivable, which can be sold to third-party collection agencies in a pinch, albeit at a
steep discount. Inventories tie up capital, and if demand shifts unexpectedly—which is
more common in some industries than others—inventory can become backlogged. A
seemingly healthy current assets balance can obscure a weak inventory turnover ratio
and other problems.
Prepaid expenses are considered current assets not because they can be
converted into cash, but because they are already taken care of, which frees up cash
for other uses. As the year progresses, the value of prepaid expenses as assets
decreases; they are amortized to reflect this fact. Prepaid expenses could include
payments to insurance companies or contractors.
Components of current assets are used to calculate a number of ratios related to a
business' liquidity. The cash ratio is the most conservative: it divides cash and cash
equivalents by current liabilities, and measures the ability of a company to pay off all of
its short-term liabilities immediately.
The quick ratio or acid-test ratio is slightly less stringent: it adds cash and cash
equivalents, marketable securities and accounts receivable, and divides the sum by
current liabilities. This gives a more realistic picture of a company's ability to meet its
short-term obligations, but can be skewed by a backlog of accounts receivable.
The current ratio is the most accommodating: it divides current assets by current
liabilities. It should be noted that in addition to accounts receivable, this measure
includes inventories, so it probably overstates liquidity in many cases, especially for
retailers and other inventory-intensive businesses.
In personal finance, current assets include cash on hand and in the bank, as well as
marketable securities that are not tied up in long-term investments. In other words,
current assets are anything of value that is highly liquid. Current assets can be used to
pay outstanding debts and cover liabilities without having to sell fixed assets.
4.3.2 Current liabilities

Current liabilities are a company's debts or obligations that are due within one year,
appearing on the company's balance sheet and include short term debt, accounts
payable, accrued liabilities and other debts.
Essentially, these are bills that are due to creditors and suppliers within a short
period of time. Normally, companies withdraw or cash current assets in order to pay
their current liabilities.
BREAKING DOWN 'Current Liabilities'

Analysts and creditors will often use the current ratio, (which divides current assets by
liabilities), or the quick ratio, (which divides current assets minus inventories by current
liabilities), to determine whether a company has the ability to pay off its current
liabilities.

In the course of conducting its operations, a company may obtain short-term loans
or acquire input materials and services from its vendors and pay for them at a later
date. Because the company has to honor these obligations in the future as a result of Notes
past transactions or events, this gives rise to corresponding liabilities. Liabilities due on
demand or within one year are classified as current liabilities on a company's balance
sheet.
Examples of Current Liabilities

Accounts payable is typically one of the largest current liability accounts on a company's
financial statements, and it represents any unpaid invoices a company has from its
suppliers of materials and services used in the production process. Other names for
current liability accounts vary by industry or government regulation, and also include
dividend payable, customer deposits, current portion of deferred revenue, current
maturities of long-term debt and interest payable. Sometimes, companies use an
account called other current liabilities as a catch-all line item on their balance sheets to
include all other liabilities due within a year not classified elsewhere.
Accounting for Current Liabilities

When a company determines it received an economic benefit that must be paid within a
year, it must immediately record a credit entry for a current liability. Depending on the
nature of the received benefit, the company's accountants classify it as either an asset
or expense. For example, consider a large car manufacturer that receives a shipment of
exhaust systems from its vendors, and must pay them $10 million within the next 90
days. Because these auto parts do not go immediately into production, the company's
accountants record a credit entry to accounts payable and a debit entry to inventory for
$10 million. When the company pays its balance due to suppliers, it debits accounts
payable and credits cash for $10 million.
Suppose a company receives tax preparation services from its external auditor for
which it must pay $1 million within the next 60 days. The company's accountants record
a $1 million debit entry to the audit services expense account and a $1 million credit
entry to the other current liabilities account. When a payment of $1 million is made, a $1
million debit entry to the other current liabilities account and a $1 million credit to the
cash account are made.
4.3.3 The Operating cycle

The operating cycle is also known as the cash conversion cycle. In the context of a
manufacturer the operating cycle has been described as the amount of time that it takes
for a manufacturer's cash to be converted into products plus the time it takes for those
products to be sold and turned back into cash. In other words, the manufacturer's
operating cycle involves:
 paying for the raw materials needed in its products
 paying for the labor and overhead costs needed to convert the raw materials into
products
 holding the finished products in inventory until they are sold
 waiting for the customers' cash payments for the products that have been sold
 Some calculate the operating cycle to be the sum of:
 the days' sales in inventory (365 days/inventory turnover ratio), plus
 the average collection period (365 days/accounts receivable turnover ratio)
The above sum is sometimes reduced by the number of days in the credit terms of
the accounts payable.
The operating cycle has importance in classifying current assets and current
liabilities. While most manufacturers have operating cycles of several months, a few
industries require very long processing times. This could result in an operating cycle

that is longer than one year. To accommodate those industries, the accountants'
definitions of current assets and current liabilities include the following phrase: ...within
Notes one year or within the operating cycle, whichever is longer.
4.3.4 Current Assets Compared with Current liabilities

Current assets can be defined as an asset on the balance sheet which is expected to
be sold or otherwise used up in the near future, usually within one year, or one
operating cycle – whichever is longer. Current assets include cash, accounts
receivable, inventory, marketable securities, prepaid expenses and other liquid assets
that can be readily converted to cash. Current assets are important to businesses
because they are the assets that are used to fund day-to-day operations and pay
ongoing expenses.
Current liabilities can be defined as those liabilities that are to be paid or settled in
cash within a year. Examples of current liability are accounts payable for goods,
outstanding expenses etc…
The difference between current asset and current liability is known as working
capital which represents operating liquidity available to business. Positive working
capital is required to make sure that a company is capable to carry on its business and
has adequate funds to satisfy both maturing short-term debt and future operational
expenses.
4.3.5 Working capital

Working capital is the amount by which the value of a company's current assets
exceeds its current liabilities. Also called net working capital. Sometimes the term
"working capital" is used as synonym for "current assets" but more frequently as "net
working capital", i.e. the amount of current assets that is in excess of current liabilities.
Working capital is frequently used to measure a firm's ability to meet current obligations.
It measures how much in liquid assets a company has available to build its business.
Working capital is a common measure of a company's liquidity, efficiency, and
overall health.
Decisions relating to working capital and short term financing are referred to as
working capital management. These involve managing the relationship between an
entity's short-term assets (inventories, accounts receivable, cash) and its short-term
liabilities.
Calculation (formula)
Working capital (net working capital) = Current Assets - Current Liabilities
Both variables are shown on the balance sheet (statement of financial position).
Norms and Limits

The number can be positive (acceptable values) or negative (unsafe values), depending
on how much debt the company is carrying. Positive working capital generally indicates
that a company is able to pay off its short-term liabilities almost immediately. In general,
companies that have a lot of working capital will be more successful since they can
expand and improve their operations.
Companies with negative working capital may lack the funds necessary for growth.
Analysts are sensitive to decreases in working capital; they suggest a company is
becoming overleveraged, is struggling to maintain or grow sales, is paying bills too
quickly, or is collecting receivables too slowly. Though in some businesses (such as
grocery retail) working capital can be negative (such business is being partly funded by
its suppliers).

Exact Formula in the Ready Ratios Analytic Software (based on the IFRS statement
format).
Notes
Working capital (net working capital) = F1 [Current Assets] – F1 [Current Liabilities]
F1 – Statement of financial position (IFRS).
The working capital ratio, also called the current, is a liquidity ratio that measures a
firm's ability to pay off its current liabilities with current assets. The working capital ratio
is important to creditors because it shows the liquidity of the company.
Current liabilities are best paid with current assets like cash, cash equivalents, and
marketable securities because these assets can be converted into cash much quicker
than fixed assets. The faster the assets can be converted into cash, the more likely the
company will have the cash in time to pay its debts.
The reason this ratio is called the working capital ratio comes from the working
capital calculation. When current assets exceed current liabilities, the firm has enough
capital to run its day-to-day operations. In other words, it has enough capital to work.
The working capital ratio transforms the working capital calculation into a comparison
between current assets and current liabilities.
Formula
The working capital ratio is calculated by dividing current assets by current liabilities.
Working Capital Ratio
Current Assets
WorkingCapitalRatio =
CurrentLiabilities
Both of these current accounts are stated separately from their respective long-
term accounts on the balance sheet. This presentation gives investors and creditors
more information to analyze about the company. Current assets and liabilities are
always stated first on financial statements and then followed by long-term assets and
liabilities.
This calculation gives you a firm understanding what percentage a firm's current
assets are of its current liabilities.
Analysis
Since the working capital ratio measures current assets as a percentage of current
liabilities, it would only make sense that a higher ratio is more favorable. A WCR of 1
indicates the current assets equal current liabilities. A ratio of 1 is usually considered
the middle ground. It's not risky, but it is also not very safe. This means that the firm
would have to sell all of its current assets in order to pay off its current liabilities.
A ratio less than 1 is considered risky by creditors and investors because it shows
the company isn't running efficiently and can't cover its current debt properly. A ratio
less than 1 is always a bad thing and is often referred to as negative working capital.
On the other hand, a ratio above 1 shows outsiders that the company can pay all of
its current liabilities and still have current assets left over or positive working capital.
Example
Since the working capital ratio has two main moving parts, assets and liabilities, it is
important to think about how they work together. In other words, how does the ratio
change if a firm's current liabilities increase while the current assets stay the same?
Here are the four examples of changes that affect the ratio:
 Current assets increase = increase in WCR
 Current assets decrease= decrease in WCR

 Current liabilities increase = decrease in WCR

Current liabilities decrease = increase in WCR
Notes 
Let's take a look at an example. Kay's Machine Shop has several loans from banks
for equipment she purchased in the last five years. All of these loans are coming due
which is decreasing her working capital. At the end of the year, Kay had $100,000 of
current assets and $125,000 of current liabilities. Here is her WCR:
Working Capital Ratio
$100,000
.80 =
$125,000
As you can see, Kay's WCR is less than 1 because her debt is increasing. This
makes her business more risky to new potential credits. If Kay wants to apply for
another loan, she should pay off some of the liabilities to lower her working capital ratio
before she applies.
4.3.6 Current ratio

The current ratio is balance-sheet financial performance measure of company liquidity.
The current ratio indicates a company's ability to meet short-term debt obligations.
The current ratio measures whether or not a firm has enough resources to pay its debts
over the next 12 months. Potential creditors use this ratio in determining whether or not
to make short-term loans. The current ratio can also give a sense of the efficiency of a
company's operating cycle or its ability to turn its product into cash. The current ratio is
also known as the working capital ratio.
The current ratio is calculated by dividing current assets by current liabilities:
The current ratio = Current Assets / Current Liabilities
Norms and Limits

The higher the ratio, the more liquid the company is. Commonly acceptable current ratio
is 2; it's a comfortable financial position for most enterprises. Acceptable current ratios
vary from industry to industry. For most industrial companies, 1.5 may be an acceptable
current ratio.
Low values for the current ratio (values less than 1) indicate that a firm may have
difficulty meeting current obligations. However, an investor should also take note of a
company's operating cash flow in order to get a better sense of its liquidity. A low
current ratio can often be supported by a strong operating cash flow.
If the current ratio is too high (much more than 2), then the company may not be
using its current assets or its short-term financing facilities efficiently. This may also
indicate problems in working capital management.
All other things being equal, creditors consider a high current ratio to be better than
a low current ratio, because a high current ratio means that the company is more likely
to meet its liabilities which are due over the next 12 months.
Exact Formula in the Ready Ratios Analytic Software

Current ratio = F1 [Current Assets]/F1 [Current Liabilities]

Current ratio (also known as working capital ratio) is a popular tool to evaluate
short-term solvency position of a business. Short-term solvency refers to the ability of a
business to pay its short-term obligations when they become due. Short term Notes
obligations (also known as current liabilities) are the liabilities payable within a short
period of time, usually one year.
Formula
Current ratio is computed by dividing total current assets by total current liabilities of the
business. This relationship can be expressed in the form of following formula or
equation:
Above formula comprises of two components i.e., current assets and current
liabilities. Both the components are available from the balance sheet of the company.
Some examples of current assets and current liabilities are given below:
Current assets Current liabilities

Cash Accounts payable / creditors
Marketable securities Accrued payable
Accounts receivables / debtors Bonds payable
Inventories / stock
Prepaid expenses
Example 1: Compute the current ratio from the following balance sheet of X Ltd:
Liabilities $ Assets $
Share capital (fully paid up) 1,000,000 Land and building 1,000,000
General reserve 800,000 Plant and machinery 400,000
Profit and loss account 300,000 inventory 300,000
Accounts payable 400,000 Accounts receivables 500,000
Cash and bank balances 300,000
———- ———-
2,500,000 2,500,000
———- ———-
Solution
= 1,100,000* / 400,000**
= 2.75 times

*Current assets: **Current liabilities:

Notes Stock 300,000 Sundry creditors 400,000
Sundry debtors 500,000
Cash 300,000
——— ———
Total current assets of X Total current liabilities of X
1,100,000 400,000
Ltd Ltd
——— ———
Significance and interpretation

Current ratio is a useful test of the short-term-debt paying ability of any business. A ratio
of 2:1 or higher is considered satisfactory for most of the companies but analyst should
be very careful while interpreting it. Simply computing the ratio does not disclose the
true liquidity of the business because a high current ratio may not always be a green
signal. It requires a deep analysis of the nature of individual current assets and current
liabilities. A company with high current ratio may not always be able to pay its current
liabilities as they become due if a large portion of its current assets consists of slow
moving or obsolete inventories. On the other hand, a company with low current ratio
may be able to pay its current obligations as they become due if a large portion of its
current assets consists of highly liquid assets i.e., cash, bank balance, marketable
securities and fast moving inventories. Consider the following example to understand
how the composition and nature of individual current assets can differentiate the
liquidity position of two companies having same current ratio figure.
Example 2
The following data has been extracted from the financial statements of two companies –
company A and company B.
Company A Company B
Current assets:
Cash $50,000 $4,000
Accounts receivable 120,000 16,000
inventory 170,000 320,000
Prepaid expenses 10,000 10,000
———— ————
Total current assets (a) 350,000 350,000
———— ————
Current liabilities (b) 175,000 175,000
———— ————
Current ratio (a)/(b) 2:1 2:1
———— ————
Both company A and company B have the same current ratio (2:1). Do both the
companies have equal ability to pay its short-term obligations?

The answer is no. Company B is likely to have difficulties in paying its short-term
obligations because most of its current assets consist of inventory. Inventory is not
quickly convertible into cash. The company A is likely to pay its current obligations as Notes
they become due because a large portion of its current assets consists of cash and
accounts receivables. Accounts receivables are highly liquid and can be converted into
cash quickly.
From this analysis, it is clear that the analyst should not only see the current ratio
but also the composition of current assets.
Limitations of current ratio

Current ratio suffers from a number of limitations. Some are given below:
Different ratio in different parts of the year: Some businesses have different
trading activities in different seasons. Such businesses may show low current ratio in
some months of the year and high in others.
Change in inventory valuation method: To compare the ratio of two companies it
is necessary that both the companies use same inventory valuation method. For
example, comparing current ratio of two companies would be like comparing apples
with oranges if one uses FIFO cost flow assumption and the other uses LIFO cost flow
assumption for the valuation of inventories. The analyst would, therefore, not be able to
compare the ratio of two companies even in the same industry.
Current ratio is a test of quantity, not quality: It is not an exact science to test
liquidity of a company because the quality of each individual asset is not taken into
account while computing this ratio.
Possibility of manipulation: Current ratio can be easily manipulated by equal
increase or equal decrease in current assets and current liabilities. For example, if
current assets of a company are $10,000 and current liabilities are $5,000, the current
ratio would be 2:1 as computed below: $10,000 : $5,000 2:1 If both current assets
and current liabilities are reduced by $1,000, the ratio would be increased to 2.25:1 as
computed below: $9,000 : $4,000 2.25:1
To reduce the effect of above limitations current ratio is usually used in conjunction
with other ratios like inventory, debt to equity ratio and quick ratio etc. These ratios can
test the quality of current assets and together with current ratio provide a better idea of
solvency.
4.3.7 Acid test ratio

The term “Acid-test ratio” is also known as quick ratio. The most basic definition of acid-
test ratio is that, “it measures current (short term) liquidity and position of the company”.
To do the analysis accountants weight current assets of the company against the
current liabilities which result in the ratio that highlights the liquidity of the company.
The formula for the acid-test ratio is:
Quick ratio = (Current Assets – Inventory) / Current liabilities
This concept is important as if the company’s financial statements (income
statement, balance sheet) get through the analysis of the acid-test ratio, then the short
term debts can be paid by the company.
Example:
Let us suppose that XYZ Company has total $2 million in its bank account and cash.
The amount of accounts receivable (short term debtors of the XYZ Company) is $11
million. The amount of short term investments is $4 million. The amount of Current
liabilities (short term credit owed to others) is $12 million. So the Acid-Test ratio of
Company X is (2million +11 million + 4 million) / (12 mill) = 1. 42.

If the value of the acid-term ratio is less than 1, then it is said that such a company
is not stable and may face difficulty is paying off their debts (short term). In order to
Notes clear the short term debts they probably would need to sell some of their assets. But
such an option affects the overall position of the company because if the company owns
very little assets.
The biggest advantage of acid-test ratio is that it helps the company in
understanding the end results very feasibly. The only major issue with the acid-test ratio
is its dependence of the accounts receivable and current liabilities which can cause
trouble. If due to any dispute the contract with the creditor or debtors gets messed up
whole of the process gets unbalanced. And also, a minor mistake in the calculation can
just destroy and conclude misleading outcomes.
The quick ratio is a measure of a company's ability to meet its short-term obligations
using its most liquid assets (near cash or quick assets). Quick assets include those
current assets that presumably can be quickly converted to cash at close to their book
values. Quick ratio is viewed as a sign of a company's financial strength or weakness; it
gives information about a company’s short term liquidity. The ratio tells creditors how
much of the company's short term debt can be met by selling all the company's liquid
assets at very short notice.
The quick ratio is also known as the acid-test ratio or quick assets ratio.
The quick ratio is calculated by dividing liquid assets by current liabilities:
Quick ratio = (Current Assets - Inventories) / Current Liabilities
Calculating liquid assets inventories are deducted as less liquid from all current
assets (inventories are often difficult to convert to cash). All of those variables are
shown on the balance sheet (statement of financial position).
Alternative and more accurate formula for the quick ratio is the following:
Quick ratio = (Cash and cash equivalents + Marketable securities + Accounts
receivable) / Current Liabilities
The formula's numerator consists of the most liquid assets (cash and cash
equivalents) and high liquid assets (liquid securities and current receivables).
Norms and Limits

The higher the quick ratio, the better the position of the company. The commonly
acceptable current ratio is 1, but may vary from industry to industry. A company with a
quick ratio of less than 1 cannot currently pay back its current liabilities; it's the bad sign
for investors and partners.
Exact Formula in the Ready Ratios Analytic Software (based on the IFRS statement
format).
Quick ratio = (F1 [Cash and Cash Equivalents] +F1 [Other Current Financial Assets]
+F1 [Trade and Other Current Receivables])/ F1 [Current Liabilities]
4.3.8 Cash ratio

Cash ratio (also called cash asset ratio) is the ratio of a company's cash and cash
equivalent assets to its total liabilities. Cash ratio is a refinement of quick ratio and
indicates the extent to which readily available funds can pay off current liabilities.
Potential creditors use this ratio as a measure of a company's liquidity and how easily it
can service debt and cover short-term liabilities.

Cash ratio is the most stringent and conservative of the three liquidity ratios
(current, quick and cash ratio). It only looks at the company's most liquid short-term
assets – cash and cash equivalents – which can be most easily used to pay off current Notes
obligations.
Cash ratio is calculated by dividing absolute liquid assets by current liabilities:
Cash ratio = Cash and cash equivalents / Current Liabilities
Norms and Limits

Cash ratio is not as popular in financial analysis as current or quick ratios, its usefulness
is limited. There is no common norm for cash ratio. In some countries a cash ratio of not
less than 0.2 is considered as acceptable. But ratio that is too high may show poor
asset utilization for a company holding large amounts of cash on its balance sheet.
Exact Formula in the Ready Ratios Analytic Software

Cash ratio = F1 [Cash and Cash Equivalents] / F1 [Current Liabilities]
4.4 Other Liquidity Consideration

Do you know how much easily accessible money you have in the form of cash and
equivalents? This is a measure of your liquidity. As you'll see, this concept plays a role
in your financial and investing lives and those of the companies you buy and sell.
Starting from a definition of liquidity with examples of different types, we'll move on to a
discussion of how banks play a role in keeping liquidity available. We'll then look at
liquidity from an investor's viewpoint in terms of the stock market. Finally, we'll end off
with a brief look at a couple of financial ratios that can be used to evaluate a company's
liquidity.
Liquidity is the term used to describe how easy it is to convert assets to cash. The
most liquid asset, and what everything else is compared to, is cash. This is because it
can always be used easily and immediately.
Certificates of deposit are slightly less liquid, because there is usually a penalty for
converting them to cash before their maturity date. Savings bonds are also quite liquid,
since they can be sold at a bank fairly easily. Finally, shares of stock, bonds, options
and commodities are considered fairly liquid, because they can usually be sold readily
and you can receive the cash within a few days. Each of the above can be considered
as cash or cash equivalents because they can be converted to cash with little effort,
although sometimes with a slight penalty. (For related reading, see The Money Market.)
Moving down the scale, we run into assets that take a bit more effort or time before
they can be realized as cash. One example would be preferred or restricted shares,
which usually have covenants dictating how and when they might be sold. Other
examples are items like coins, stamps, art and other collectibles. If you were to sell to
another collector, you might get full value but it could take a while, even with the internet
easing the way. If you go to a dealer instead, you could get cash more quickly, but you
may receive less of it. (For further reading, see Contemplating Collectible Investments
and A Primer on Preferred Stocks.)
The least liquid asset is usually considered to be real estate because that can take
weeks or months to sell.
When we invest in any assets, we need to keep their liquidity levels in mind
because it can be difficult or time consuming to convert certain assets back into cash.

Other than selling an asset, cash can be obtained by borrowing against it. While this
may be done privately between two people, it is more often done through a bank. A
Notes bank has the cash from many depositors pooled together and can more easily meet the
needs of any borrower.
Furthermore, if a depositor needs cash right away, that person can just withdraw it
from the bank rather than going to the borrower and demanding payment of the entire
note. Thus, banks act as financial intermediaries between lenders and borrowers,
allowing for a smooth flow of money and meeting the needs of each side of a loan.
Liquidity and the Stock Market

In the market, liquidity has a slightly different meaning, although still tied to how easily
assets, in this case shares of stock, can be converted to cash. The market for a stock is
said to be liquid if the shares can be rapidly sold and the act of selling has little impact
on the stock's price. Generally, this translates to where the shares are traded and the
level of interest that investors have in the company. Company stock traded on the major
exchanges can usually be considered liquid. Often, approximately 1% of the float trades
hands daily, indicating a high degree of interest in the stock. On the other hand,
company stock traded on the pink sheets or over the counter are often non-liquid, with
very few, even zero, shares traded daily.
Another way to judge liquidity in a company's stock is to look at the bid/ask spread.
For liquid stocks, such as Microsoft or General Electric, the spread is often just a few
pennies - much less than 1% of the price. For illiquid stocks, the spread can be much
larger, amounting to a few percent of the trading price. (For more insight, see Why the
Bid-Ask Spread Is So Important.)
One thing to note as an investor when placing an order, is the liquidity of the stock.
During normal market hours on the major exchanges, placing a limit order will get you
the price you are looking for. This is particularly true for companies that are non-liquid,
or during after-hours trading when fewer traders are active; at these times, it is better to
place a limit order because the lower liquidity may lead to a price you would not be
willing to pay.
Liquidity and Companies

One last understanding of liquidity is especially important for investors: the liquidity of
companies that we may wish to invest in.
Cash is a company's lifeblood. In other words, a company can sell lots of widgets
and have good net earnings, but if it can't collect the actual cash from its customers on
a timely basis, it will soon fold up, unable to pay its own obligations. (To read more,
check out The Essentials of Cash Flow and Spotting Cash Cows.)
Several ratios look at how easily a company can meet its current obligations. One of
these is the current ratio, which compares the level of current assets to current
liabilities. Remember that in this context, "current" means collectible or payable within
one year. Depending on the industry, companies with good liquidity will usually have a
current ratio of more than two. This shows that a company has the resources on hand
to meet its obligations and is less likely to borrow money or enter bankruptcy.
A more stringent measure is the quick ratio, sometimes called the acid test ratio.
This uses current assets (excluding inventory) and compares them to current liabilities.
Inventory is removed because, of the various current assets such as cash, short-term
investments or accounts receivable, this is the most difficult to convert into cash. A
value of greater than one is usually considered good from a liquidity viewpoint, but this
is industry dependent. (To read more, see The Dynamic Current Ratio and Analyze
Investments Quickly with Ratios.)
One last ratio of note is the debt/equity ratio, usually defined as total liabilities
divided by stockholders' equity. While this does not measure a company's liquidity
directly, it is related. Generally, companies with a higher debt/equity ratio will be less
liquid, as more of their available cash must be used to service and reduce the debt. This
leaves less cash for other purposes.
Notes
Bottom Line
Liquidity is important for both individuals and companies. While a person may be rich in
terms of total value of assets owned, that person may also end up in trouble if he or she
is unable to convert those assets into cash. The same holds true for companies.
Without cash coming in the door, they can quickly get into trouble with their creditors.
Banks are important for both groups, providing financial intermediation between those
who need cash and those who can offer it, thus keeping the cash flowing. An
understanding of the liquidity of a company's stock within the market helps investors
judge when to buy or sell shares. Finally, an understanding of a company's own liquidity
helps investors avoid those that might run into trouble in the near future.
4.4.1 Sales to working capital turnover ratio

The working capital turnover ratio measures how well a company is utilizing its working
capital to support a given level of sales. Working capital is current assets minus current
liabilities. A high turnover ratio indicates that management is being extremely efficient in
using a firm's short-term assets and liabilities to support sales. Conversely, a low ratio
indicates that a business is investing in too many accounts receivable and inventory
assets to support its sales, which could eventually lead to an excessive amount of bad
debts and obsolete inventory.
Working Capital Turnover Formula

To calculate the ratio, divide net sales by working capital (which is current assets minus
current liabilities). The calculation is usually made on an annual or trailing 12-month
basis, and uses the average working capital during that period. The calculation is:
Net sales (Beginning working capital + Ending working capital) / 2
Working Capital Turnover Example

ABC Company has $12,000,000 of net sales over the past twelve months, and average
working capital during that period of $2,000,000. The calculation of its working capital
turnover ratio is:
$12,000,000 Net sales
$2,000,000 Average working capital
= 6.0 working capital turnover ratio
Issues with the Measurement

An extremely high working capital turnover ratio can indicate that a company does not
have enough capital to support it sales growth; collapse of the company may be
imminent. This is a particularly strong indicator when the accounts payable component
of working capital is very high, since it indicates that management cannot pay its bills as
they come due for payment.
An excessively high turnover ratio can be spotted by comparing the ratio for a
particular business to those reported elsewhere in its industry, to see if the business is
reporting outlier results.
It usually takes a certain amount of invested cash to maintain sales. There must be
an investment in accounts receivable and inventory, against which accounts payable
are offset. Thus, there is typically a ratio of working capital to sales that remains
relatively constant in a business, even as sales levels change.
This relationship can be measured with the sales to working capital ratio, which
should be reported on a trend line to more easily spot spikes or dips. A spike in the ratio

could be caused by a decision to grant more credit to customers in order to encourage

more sales, while a dip could signal the reverse. A spike might also be triggered by a
Notes decision to keep more inventories on hand in order to more easily fulfill customer
orders. Such a trend line is an excellent feedback mechanism for showing management
the results of its decisions related to working capital.
The sales to working capital ratio is calculated by dividing annualized net sales by
average working capital. The formula is:
Annualized net sales

Accounts receivable + Inventory - Accounts payable
Management should be cognizant of the problems that can arise if it attempts to
alter the outcome of this ratio. For example, tightening credit reduces sales, shrinking
inventory may also reduce sales, and lengthening payment terms to suppliers can lead
to strained relations with them.
Example of the Sales to Working Capital Ratio

A credit analyst is reviewing the sales to working capital ratio of Milford Sound, which
has applied for credit. Milford has been adjusting its inventory levels over the past few
quarters, with the intent of doubling inventory turnover from its current level. The result
is shown in the following table:
Quarter 1 Quarter 2 Quarter 3 Quarter 4
Revenue $640,000 $620,000 $580,000 $460,000
Accounts Receivable 214,000 206,000 194,000 186,000
Inventory 1,280,000 640,000 640,000 640,000
Accounts Payable 106,000 104,000 96,000 94,000
Total Working Capital 1,388,000 742,000 738,000 732,000
Sales to Working Capital 1.8:1 3.3:1 3.1:1 3.1:1

Ratio
The table includes a quarterly ratio calculation that is based on annualized sales.
The table reveals that Milford achieved its goal of reducing inventory, but at the cost of
a significant sales reduction, probably caused by customers turning to competitors who
offered a larger selection of inventory.
4.4.2 Income statement consideration when determining debt-paying ability

The firm’s ability to carry debt, as indicated by the income statement, can be viewed by
considering the times interest earned and the fixed charge coverage. These ratios are
now reviewed.
Times Interest Earned

The times interest earned ratio indicates a firm’s long-term debt-paying ability from
the income statement view. If the times interest earned is adequate, little danger exists
that the firm will not be able to meet its interest obligation. If the firm has good coverage
of the interest obligation, it should also be able to refinance the principal when it comes
due. In effect, the funds will probably never be required to pay off the principal if the
company has a good record of covering the interest expense. A relatively high, stable
coverage of interest over the years indicates a good record. A low, fluctuating coverage
from year to year indicates a poor record.

Companies that maintain a good record can finance a relatively high proportion of
debt in relation to stockholders’ equity and, at the same time, obtain funds at favorable
rates. Notes
Utility companies have traditionally been examples of companies that have a high
debt structure, in relation to stockholders’ equity. They accomplished this because of
their relatively high, stable coverage of interest over the years. This stability evolved in
an industry with a regulated profit and a relatively stable demand. During the 1970s,
1980s, and 1990s, utilities experienced a severe strain on their profits, as rate increases
did not keep pace with inflation. In addition, the demand was not as predictable as in
prior years. The strain on profits and the uncertainty of demand influenced investors to
demand higher interest rates from utilities than had been previously required in relation
to other companies.
A company issues debt obligations to obtain funds at an interest rate less than the
earnings from these funds. This is called trading on the equity or leverage. With a
high interest rate, the added risk exists that the company will not be able to earn more
on the funds than the interest cost on them.
Compute times interest earned as follows:
RecurringEarnings,ExcludingInterestExpense,
TaxExpense,EquityEarnings,andMinorityEarnings
Times Interest Earned =
InterestExpense,IncludingCapitalizedInte rest
The income statement contains several figures that might be used in this analysis.
In general, the primary analysis of the firm’s ability to carry the debt as indicated by the
income statement should include only income expected to occur in subsequent periods.
Thus, the following nonrecurring items should be excluded:
 Discontinued operations
 Extraordinary items
 Cumulative effect of a change in accounting principle
In addition to these nonrecurring items, additional items that should be excluded for
the times interest earned computation include:
 Interest expense. This is added back to net income because the interest coverage
would be understated by one if interest expense were deducted before computing
times interest earned.
 Income tax expense. Income taxes are computed after deducting interest
expense, so they do not affect the safety of the interest payments.
 Equity earnings (losses) of non-consolidated subsidiaries. These are excluded
because they are not available to cover interest payments, except to the extent that
they are accompanied by cash dividends.
 Minority income (loss). This adjustment at the bottom of the income statement
should be excluded; use income before minority interest. Minority income (loss)
results from consolidating a firm in which a company has control but less than 100%
ownership. All of the interest expense of the firm consolidated is included in the
consolidated income statement. Therefore, all of the income of the firm consolidated
should be considered in the coverage.
Capitalization of interest results in interest being added to a fixed asset instead of
expensed. The interest capitalized should be included with the total interest expense in
the denominator of the times interest earned ratio because it is part of the interest
payment. The capitalized interest must be added to the interest expense disclosed on
the income statement or in footnotes.
An example of capitalized interest would be interest during the current year on a
bond issued to build a factory. As long as the factory is under construction, this interest

would be added to the asset account, construction in process, on the balance sheet.
This interest does not appear on the income statement, but it is as much of a
Notes commitment as the interest expense deducted on the income statement.
When the factory is completed, the annual interest on the bond issued to build the
factory will be expensed. When expensed, interest appears on the income statement.
Capitalized interest is usually disclosed in a footnote. Some firms describe the
capitalized interest on the face of the income statement.
Figure shows times interest earned for Nike for the years 1999 and 1998. Many
would consider this ratio to be high. To evaluate the adequacy of coverage, the times
interest earned ratio should be computed for a period of three to five years and
compared to competitors and the industry average. Computing interest earned for three
to five years provides insight on the stability of the interest coverage. Because the firm
needs to cover interest in the bad years as well as the good years, the lowest times
interest earned in the period is used as the primary indication of the interest coverage.
A cyclical firm may have a very high times interest earned ratio in highly profitable
years, but interest may not be covered in low profit years.
Nike, Inc.
Interest coverage on long-term debt is sometimes computed separately from the

normal times interest earned. For this purpose only, use the interest on long-term debt,
thus focusing on the long-term interest coverage. Since times interest earned indicates
long-term debt-paying ability, this revised computation helps focus on the long-term
position. For external analysis, it is usually not practical to compute times interest
coverage on long-term debt because of the lack of data. However, this computation can
be made for internal analysis.
In the long run, a firm must have the funds to meet all of its expenses. In the short
run, a firm can often meet its interest obligations even when the times interest earned is
less than 1.00. Some of the expenses, such as depreciation expense, amortization
expense, and depletion expense, do not require funds in the short run. The airline
industry has had several bad periods when the times interest earned was less than
1.00, but it was able to maintain the interest payments.
To get a better indication of a firm’s ability to cover interest payments in the short
run, the noncash expenses such as depreciation, depletion, and amortization can be
added back to the numerator of the times interest earned ratio. The resulting ratio,
which is less conservative, gives a type of cash basis time’s interest earned useful for
evaluating the firm in the short run.
Figure shows that Nike’s short-run times interest earned ratio is substantially higher
than its long-run ratio.
Fixed Charge Coverage

The fixed charge coverage ratio, an extension of the times interest earned ratio, also
indicates a firm’s long-term debt-paying ability from the income statement view. The
fixed charge coverage ratio indicates a firm’s ability to cover fixed charges. It is
computed as follows:

RecurringEarnings,ExcludingInterestExpense,TaxExpense,
Fixed Charge Coverage= EquityEarnings,andMinorityEarnings + InterestPortionof Rentals
InterestExpense,IncludingCapitalizedInte rest
Notes
+InterestPortion of Rentals
A difference of opinion occurs in practice as to what should be included in the fixed

charges. When assets are leased, the lessee classifies leases as either capital leases
or operating leases. The lessee treats a capital lease as an acquisition and includes the
leased asset in fixed assets and the related obligation in liabilities. Part of the lease
payment is considered to be interest expense. Therefore, the interest expense on the
income statement includes interest related to capital leases.
A portion of operating lease payments is an item frequently included in addition to

interest expense. Operating leases are not on the balance sheet, but they are reflected
on the income statement in the rent expense. An operating lease for a relatively long
term is a type of long-term financing, so part of the lease payment is really interest.
When a portion of operating lease payments is included in fixed charges, it is an effort
to recognize the true total interest that the firm pays.
SEC reporting may require a more conservative computation than the times interest
earned ratio in order to determine the firm’s long-term debt-paying ability. The SEC
refers to its ratio as the ratio of earnings to fixed charges. The major difference
between the times interest earned computation and the ratio of earnings to fixed
charges is that the latter computation includes a portion of the operating leases.
Usually, one-third of the operating leases’ rental charges is included in the fixed
charges because this is an approximation of the proportion of lease payment that is
interest. The SEC does not accept the one-third approximation automatically, but
requires a more specific estimate of the interest portion based on the terms of the lease.
Individuals interested in a company’s ratio of earnings to fixed charges can find this
ratio on the face of the income statement included with the SEC registration statement
(Form S-7) when debt securities are registered.
The same adjusted earnings figure is used in the fixed charge coverage ratio as is
used for the times interest earned ratio, except that the interest portion of operating
leases (rentals) is added to the adjusted earnings for the fixed charge coverage ratio.
The interest portion of operating leases is added to the adjusted earnings because it
was previously deducted on the income statement as rental charges.
Nike’s 1999 annual report disclosed “the Company leases space for its offices,
warehouses and retail stores under leases expiring from one to eighteen years after
May 31, 1999.Rent expense aggregated $129.5 million, $129.6 million and $84.1 million
for the years ended May 31, 1999, 1998 and 1997, respectively.”

Figure shows the fixed charge coverage for Nike for 1999 and 1998, with the
interest portion of rentals considered. This figure, more conservative than the times
Notes interest earned, is still very good for Nike.
Among the other items sometimes considered as fixed charges are depreciation,
depletion and amortization, debt principal payments, and pension payments.
Substantial preferred dividends may also be included, or a separate ratio may be
computed to consider preferred dividends. The more items considered as fixed charges,
the more conservative the ratio. The trend is usually similar to that found for the times
interest earned ratio.
4.5 Balance Sheet Consideration when Determining Debt-paying

Ability
The firm’s ability to carry debt, as indicated by the balance sheet, can be viewed by
considering the debt ratio and the debt / equity ratio. These ratios are now reviewed.
Debt Ratio
The debt ratio indicates the firm’s long-term debt-paying ability. It is computed as
follows:
Total liabilities include short-term liabilities, reserves, deferred tax liabilities, minority
shareholders’ interests, redeemable preferred stock, and any other noncurrent liability.
It does not include stockholders’ equity.
The debt ratio indicates the percentage of assets financed by creditors, and it helps
to determine how well creditors are protected in case of insolvency. If creditors are not
well protected, the company is not in a position to issue additional long-term debt. From
the perspective of long-term debt-paying ability, the lower this ratio, the better the
company’s position.
Figure shows the debt ratio for Nike for May 31, 1999, and May 31, 1998. The
Figure indicates that substantially less than one-half of the Nike assets were financed
by outsiders in both 1999 and 1998. This debt ratio is a conservative computation
because all of the liabilities and near liabilities have been included. At the same time,
the assets are understated because no adjustments have been made for assets that
have a fair market value greater than book value.
The debt ratio should be compared with competitors and industry averages.
Industries that have stable earnings can handle more debt than industries that have
cyclical earnings.

Nike, Inc.
Notes
This comparison can be misleading if one firm has substantial hidden assets that
other firms do not (such as substantial land carried at historical cost).
In practice, substantial disagreement occurs on the details of the formula to
compute the debt ratio. Some of the disagreement revolves around whether short-term
liabilities should be included. Some firms exclude short-term liabilities because they are
not long-term sources of funds and are, therefore, not a valid indication of the firm’s
long-term debt position. Other firms include short-term liabilities because these liabilities
become part of the total source of outside funds in the long run. For example, individual
accounts payable are relatively short term, but accounts payable in total becomes a
rather permanent part of the entire sources of funds.
Another issue involves whether certain other items should be included in liabilities.
Under current GAAP, some liabilities clearly represent a commitment to pay out funds in
the future, whereas other items may never result in a future payment. Items that present
particular problems as to a future payment of funds include reserves, deferred taxes,
minority shareholders’ interests, and redeemable preferred stock. Each of these items
will be reviewed in the sections that follow.
Reserves
The reserve accounts classified under liabilities (some short-term and some long-term)
result from an expense charge to the income statement and an equal increase in the
reserve account on the balance sheet. These reserve accounts do not represent
definite commitments to pay out funds in the future, but they are estimates of funds that
will be paid out.
Reserve accounts are used infrequently in U.S. financial reporting. It is thought that
they provide too much discretion in determining the amount of the reserve and the
related impact on reported income. When the reserve account is increased, income is
reduced.
When the reserve account is decreased, an asset is decreased. Reserve accounts
are popular in some other countries like Germany.
An example of a reserve appeared in the 1998 United Technologies annual report.
The disclosure reads in part:
The Corporation extends performance and operating cost guarantees, which are
beyond its normal warranty and service policies, for extended periods on some of its
products, particularly commercial aircraft engines. Liability under such guarantees is
contingent upon future product performance and durability. The Corporation has
accrued its estimated liabilities that may result under these guarantees.
Deferred Taxes (Interperiod Tax Allocation)

In the United States, a firm may recognize certain income and expense items in one
period for the financial statements and in another period for the federal tax return. This

can result in financial statement income in any one period that is substantially different
from tax return income. For many other countries, this is not the case. For example,
Notes there are few timing differences in Germany, and there are no timing differences in
Japan. For these countries, deferred taxes are not a substantial issue or are not an
issue.
In the United States, taxes payable based on the tax return can be substantially
different from income tax expense based on financial statement income. Current GAAP
directs that the tax expense for the financial statements be based on the tax-related
items on the financial statements. Taxes payable are based on the actual current taxes
payable, determined by the tax return. (The Internal Revenue Code specifies the
procedures for determining taxable income.)
The tax expense for the financial statements often does not agree with the taxes
payable.
The difference between tax expense and taxes payable is recorded as deferred
income taxes.
The concept that results in deferred income taxes is called interperiod tax
allocation.
As an illustration of deferred taxes, consider the following facts related to machinery
purchased for $100,000:
For both tax and financial statement purposes, $100,000 was written off for the
equipment. The write-off on the tax return was three years, while the write-off on the
financial statements was five years. The faster write-off on the tax return resulted in
lower taxable income than the income reported on the income statement during the first
three years. During the last two years, the income statement income was lower than the
tax return income.
In addition to temporary differences, the tax liability can be influenced by
an operating loss carry back and/or operating loss carry forward. The tax code allows a
corporation reporting an operating loss for income tax purposes in the current year to
carry this loss back and forward to offset reported taxable income. The company may
first carry an operating loss back two years in sequential order, starting with the earliest
of the two years. If the taxable income for the past two years is not enough to offset the
operating loss, then the remaining loss is sequentially carried forward 20 years and
offset against future taxable income.
A company can elect to forgo a carry back and, instead, only carry forward an
operating loss. A company would not normally forgo a carry back because an operating
loss carries back results in a definite and immediate income tax refund. A carry forward
will reduce income taxes payable in future years to the extent of earned taxable income.
A company could possibly benefit from forgoing a carry back if prospects in future years
are good and an increase in the tax rate is anticipated.
Interperiod tax allocation should be used for all temporary differences. A temporary
difference between the tax basis of an asset or liability and its reported amount in the
financial statements will result in taxable or deductible amounts in future years when the
reported amount of the asset or liability is recovered or settled, respectively.
Notes
A corporation reports deferred taxes in two classifications: a net current amount and
a net noncurrent amount. The net current amount could result in a current asset or a
current liability being reported. The net noncurrent amount could result in a noncurrent
asset or a non-current liability being reported.
Classification as current or noncurrent is usually based on the classification of the
asset or liability responsible for the temporary difference. For example, a deferred tax
liability resulting from the excess of tax depreciation over financial reporting
depreciation would be reported as a noncurrent liability. This is because the temporary
difference is related to non-current assets (fixed assets).
When a deferred tax asset or liability is not related to an asset or liability, the
deferred tax asset or liability is classified according to the expected reversal date of the
temporary difference. For example, a deferred tax amount resulting from an operating
loss carry forward would be classified based on the expected reversal date of the
temporary difference.
There should be a valuation allowance against a deferred tax asset if sufficient
uncertainty exists about a corporation’s future taxable income. A valuation allowance
reduces the deferred tax asset to its expected realizable amount. At the time that the
valuation allowance is recognized, tax expense is increased.
A more likely than not criterion is used to measure uncertainty. If more likely than
not a deferred asset will not be realized, a valuation allowance would be required.
Nike discloses deferred taxes in long-term assets and long-term liabilities. For many
firms, the long-term liability, deferred taxes, has grown to a substantial amount, which
often increases each year. This occurs because of the growth in the temporary
differences that cause the timing difference. The Nike amount increased substantially in
1999 for the long-term liability. Much of this increase was related to depreciation.
Deferred taxes must be accounted for, using the liability method, which focuses on
the balance sheet. Deferred taxes are recorded at amounts at which they will be settled
when underlying temporary differences reverse. Deferred taxes are adjusted for tax rate
changes. A change in tax rates can result in a material adjustment to the deferred
account and can substantially influence income in the year of the tax rate change.
Some individuals disagree with the concept of deferred taxes (interperiod tax
allocation). It is uncertain that the deferred tax will be paid. If it will be paid (received), it
is uncertain when it will be paid (or received). The deferred tax accounts are, therefore,
often referred to as soft accounts.
Because of the uncertainty over whether (and when) a deferred tax liability (asset)
will be paid (received), some individuals elect to exclude deferred tax liabilities and
assets when performing analysis. This is inconsistent with GAAP, which recognize
deferred taxes.
Some revenue and expense items, referred to as permanent differences, never go
on the tax return, but do go on the income statement. Examples would be premiums on
life insurance and life insurance proceeds. Federal tax law does not allow these items to
be included in expense and revenue, respectively. These items never influence either
the tax expense or the tax liability, so they never influence the deferred tax accounts.
Minority Shareholders’ Interest

The account, minority shareholders’ interest, results when the firm has consolidated
another company of which it owns less than 100%. The proportion of the consolidated
company that is not owned appears on the balance sheet just above stockholders’
equity.

Some firms exclude the minority shareholders’ interest when computing debt ratios
because this amount does not represent a commitment to pay funds to outsiders. Other
Notes firms include the minority shareholders’ interest when computing debt ratios because
these funds came from outsiders and are part of the total funds that the firm uses.
Redeemable Preferred Stock

Redeemable preferred stock is subject to mandatory redemption requirements or has
are redemption feature outside the control of the issuer. Some redeemable preferred
stock agreements require the firm to purchase certain amounts of the preferred stock on
the open market. The Securities and Exchange Commission dictates that redeemable
preferred stocks are not be disclosed under stockholders’ equity.
The nature of redeemable preferred stock leaves open to judgment how it should be
handled when computing debt ratios. One view excludes it from debt and includes it in
stockholders’ equity, on the grounds that it does not represent a normal debt
relationship. A conservative position includes it as debt when computing the debt ratios.
Debt / Equity Ratio

The debt/equity ratio is another computation that determines the entity’s long-term debt-
paying ability. This computation compares the total debt with the total shareholders
’equity. The debt/equity ratio also helps determine how well creditors are protected in
case of insolvency. From the perspective of long-term debt-paying ability, the lower this
ratio is, the better the company’s debt position.
The computation of the debt / equity ratio is conservative because all of the
liabilities and near liabilities are included, and the stockholders’ equity is understated to
the extent that assets have a value greater than book value. This ratio should also be
compared with industry averages and competitors. Compute the debt / equity ratio as
follows:
TotalLiabilities
Debt/Equity Ratio=
Shareholders'Equity
Figure shows the debt / equity ratio for Nike for May 31, 1999, and May 31, 1998.
Using a conservative approach to computing debt / equity, Figure indicates the debt /
equity ratio was 57.37% at the end of 1999, down from 65.48% at the end of 1998.
The debt ratio and the debt / equity ratio have the same objectives. Therefore,
these ratios are alternatives to each other if computed in the manner recommended
here. Because some financial services may be reporting the debt ratio and others may
be reporting the debt / equity ratio, the reader should be familiar with both.
As indicated previously, a problem exists with the lack of uniformity in the way some
ratios are computed. This especially occurs with the debt ratio and the debt / equity
ratio. When comparing the debt ratio and the debt / equity ratio with industry ratios, try
to determine how the industry ratios were computed. A reasonable comparison may not
be possible because the financial sources sometimes do not indicate what elements of
debt the computations include.
Nike, Inc.,

Debt to Tangible Net worth Ratio
The debt to tangible net worth ratio also determines the entity’s long-term debt-paying Notes
ability. This ratio also indicates how well creditors are protected in case of the firm’s
insolvency.
As with the debt ratio and the debt / equity ratio, from the perspective of long-term
debt-paying ability, it is better to have a lower ratio. The debt to tangible net worth ratio
is a more conservative ratio than either the debt ratio or the debt / equity ratio. It
eliminates intangible assets, such as goodwill, trademarks, patents, and copyrights,
because they do not provide resources to pay creditors - a very conservative position.
Compute the debt to tangible net worth ratio as follows:
TotalLiabilities
Debt to Tangible Net Worth Ratio=
Shareholders'Equity – Intangible Assets
All of the liabilities and near liabilities are included, and the stockholders’ equity is
understated to the extent that assets have a value greater than book value.
Figure shows the debt to tangible net worth ratios for Nike for May 31, 1999, and
May 31, 1998. This is a conservative view of the debt-paying ability.
Other Long-Term Debt-Paying Ability Ratios

A number of additional ratios indicate perspective on the long-term debt-paying ability of
a firm. This section describes some of these ratios.
The current debt / net worth ratio indicates a relationship between current liabilities
and funds contributed by shareholders. The higher the proportion of funds provided by
current liabilities, the greater the risk.
Another ratio, the total capitalization ratio, compares long-term debt to total
capitalization. Total capitalization consists of long-term debt, preferred stock, and
common stockholders’ equity. The lower the ratio, the lower the risk.
Another ratio, the fixed asset / equity ratio, indicates the extent to which
shareholders have provided funds in relation to fixed assets. Some firms subtract
intangibles from shareholders ‘equity to obtain tangible net worth. This results in a more
conservative ratio. The higher the fixed assets in relation to equity, the greater the risk.
Figure on the following page indicates the trend in current liabilities, total liabilities,
and owner’s equity of firms in the United States between 1964 and 1998. It shows that
there has been a major shift in the capital structure of firms, toward a higher proportion
of
Nike, Inc.

Trends in Current Liabilities, Long-Term Liabilities, And Owner’s Equity 1964 –

1998
Notes
Debt in relation to total assets. This indicates a substantial increase in risk as

management more frequently faces debt coming due. It also indicates that short-term
debt is a permanent part of the financial structure of firms. This supports the decision to
include short-term liabilities in the ratios determining long-term debt-paying ability (debt
ratio, debt / equity ratio, and debt to tangible net worth ratio).
Practice Test
The balance sheet reports a company's assets, liabilities, and stockholders' equity as of
a specific date, such as December 31, 2015, March 31, 2015, etc.
The accountants' cost principle and the monetary unit assumption will limit the
assets reported on the balance sheet. Assets will be reported
1. Only if they were acquired in a transaction, and
2. Generally at an amount that is not greater than the asset's cost at the time of the
transaction.
This means that a company's creative and effective management team will not be
listed as an asset. Similarly, a company's outstanding reputation, its unique product
lines, and brand names developed within the company will not be reported on the
balance sheet. As you may surmise, these items are often the most valuable of all the
things owned by the company. (Brand names purchased from another company will be
recorded in the company's accounting records at their cost.)
The accountants' matching principle will result in assets such as buildings,
equipment, furnishings, fixtures, vehicles, etc. being reported at amounts less than cost.
The reason is these assets are depreciated. Depreciation reduces an asset's book
value each year and the amount of the reduction is reported as Depreciation Expense
on the income statement.
While depreciation is reducing the book value of certain assets over their useful
lives, the current value (or fair market value) of these assets may actually be increasing.
(It is also possible that the current value of some assets—such as computers—may be
decreasing faster than the book value.)
Current assets such as Cash, Accounts Receivable, Inventory, Supplies, Prepaid
Insurance, etc. usually have current values that are close to the amounts reported on
the balance sheet.
Current liabilities such as Notes Payable (due within one year), Accounts Payable,
Wages Payable, Interest Payable, Unearned Revenues, etc. are also likely to have
current values that are close to the amounts reported on the balance sheet.
Long-term liabilities such as Notes Payable (not due within one year) or Bonds
Payable (not maturing within one year) will often have current values that differ from the
amounts reported on the balance sheet. Notes
Stockholders' equity is the book value of the company. It is the difference between
the reported amount of assets and the reported amount of liabilities. For the reasons
mentioned above, the reported amount of stockholders' equity will therefore be different
from the current or market value of the company.
By definition the current assets and current liabilities are "turning over" at least once
per year. As a result, the reported amounts are likely to be similar to their current value.
The long-term assets and long-term liabilities are not "turning over" often. Therefore, the
amounts reported for long-term assets and long-term liabilities will likely be different
from the current value of those items.
The remainder of our explanation of financial ratios and financial statement analysis
will use information from the following balance sheet:
Common-Size Balance Sheet

One technique in financial statement analysis is known as vertical analysis. Vertical
analysis results in common-size financial statements. A common-size balance sheet is
a balance sheet where every dollar amount has been restated to be a percentage of
total assets. We will illustrate this by taking Example Company's balance sheet (shown
above) and divide each item by the total asset amount $770,000. The result is the
following common-size balance sheet for Example Company:

Notes
The benefit of a common-size balance sheet is that an item can be compared to a

similar item of another company regardless of the size of the companies. A company
can also compare its percentages to the industry's average percentages. For example,
a company with Inventory at 4.0% of total assets can look to its industry statistics to see
if its percentage is reasonable. (Industry percentages might be available from an
industry association, library reference desks, and from bankers. Many banks have
memberships in Risk Management Association (RMA), an organization that collects and
distributes statistics by industry.) A common-size balance sheet also allows two
businesspersons to compare the magnitude of a balance sheet item without either one
revealing the actual dollar amounts.
4.6 Summary
The liquidity of short-term assets and the short-term debt-paying ability of the company
can be measured by the liquidity ratio analysis, including calculation of the following
indicators:
Current Ratio = Current Assets ÷ Current Liabilities
Quick ratio (Acid Test Ratio) = (Cash Equivalents + Marketable Securities + Net
Receivables) ÷ (Current Liabilities)
Quick Ratio = (Cash + Marketable Securities + Accounts and Notes Receivable) ÷
Current Liabilities
Quick Ratio = (Current assets - Inventory) ÷ Current liabilities
Cash Ratio = (Cash Equivalents + Marketable Securities) ÷ Current Liabilities

Working Capital = Current Assets - Current Liabilities
Sales to Working Capital (Working Capital Turnover) = Sales ÷ Average Working Notes
Capital
Although they may seem intimidating at first glance, all of the aforementioned
financial ratios can be derived by simply comparing numbers that appear on a small
business's income statement and balance sheet. Small business owners would be well-
served by familiarizing themselves with ratios and their uses as a tracking device for
anticipating changes in operations.
Financial ratios can be an important tool for small business owners and managers
to measure their progress toward reaching company goals, as well as toward competing
with larger companies. Ratio analysis, when performed regularly over time, can also
help small businesses recognize and adapt to trends affecting their operations. Yet
another reason small business owners need to understand financial ratios is that they
provide one of the main measures of a company's success from the perspective of
bankers, investors, and business analysts. Often, a small business's ability to obtain
debt or equity financing will depend on the company's financial ratios.
Despite all the positive uses of financial ratios, however, small business managers
are still encouraged to know the limitations of ratios and approach ratio analysis with a
degree of caution. Ratios alone do not make give one all the information necessary for
decision making. But decisions made without a look at financial ratios, the decision is
being made without all the available data.
4.7 Check Your Progress

Multiple Choice Questions
1. We can say that the business is in profit, when:
(a) Assets exceed Expenditure
(b) Income exceeds Liabilities
(c) Income exceeds Expenditure
(d) Income exceeds Liabilities
2. According to the double entry system of accounting, an account that obtains benefit
is:
(a) Credit
(b) Debit
(c) Income
(d) No need to show as accounting record
3. Term "Credit" means_______ by the business.
(a) Receiving of benefits
(b) It has no effect on business
(c) Providing of benefits
(d) It depends upon items
4. When a Liability is reduced or decreased, it is recorded on the:
(a) Left or credit side of the account
(b) Right or debit side of the account
(c) Right or credit side of the account
(d) Left or debit side of the account
5. When Capital is increased by an amount, it is recorded on the:
(a) Right or debit side of the account

(b) Left or credit side of the account

(c) Left or debit side of the account
Notes
(d) Right or credit side of the account
6. What type of expenses are paid out of Gross Profit?
(a) General Expenses
(b) Financial Expenses
(c) Selling Expenses
(d) All of the given options
7. Which of the following shows summary of a company's financial position at a
specific date?
(a) Profit & Loss Account
(b) Cash Flow Statement
(c) Balance Sheet
(d) Income & Expenditure Account
8. Which of the following is NOT an example of intangible assets?
(a) Franchise rights
(b) Goodwill
(c) Patents
(d) Land
9. Which of the following is an example of business liability?
(a) Land
(b) Building
(c) Cash
(d) Creditors
10. The unfavorable balance of Profit and Loss account should be:
(a) Added in liabilities
(b) Subtracted from current assets
(c) Subtracted from capital
(d) Subtracted from liabilities
4.8 Questions and Exercises

1. What are financial ratios?
2. Explain the term financial rations as perceived by corporate controllers.
3. Explain the Most significant ratios and their primary measure.
4. Discuss the key financial ratios included as Corporate Objectives.
5. Explain the Financial Ratios used in Annual Reports.
6. Discuss the Related debt paying ability & Long-term Debt-paying Ability.
7. Explain Current Assets, Current liabilities and the Operating cycle.
8. Discuss the Current Assets Compared with Current liabilities.
9. Discuss the Other liquidity consideration.
10. Explain Income statement consideration when determining debt-paying ability.

4.9 Key Terms
 Contingent liabilities: liabilities not recorded on a company's financial reports, but Notes
which might become due. If a company is being sued, it has a contingent liability
that will become a real liability if the company loses the suit.
 Cost of sales, cost of goods sold: the expense or cost of all items sold during an
accounting period. Each unit sold has a cost of sales or cost of the goods sold. In
businesses with a great many items flowing through, the cost of sales or cost of
goods sold is often computed by this formula: Cost of Sales = Beginning Inventory +
Purchases During the Period ‐ Ending Inventory.
 Credit: an accounting entry on the right or bottom of a balance sheet. Usually an
increase in liabilities or capital, or a reduction in assets. The opposite of credit is
debit. Each credit in a balance sheet has a balancing debit. Credit has other
usages, as in "You have to pay cash, and your credit is no good." Or "we will credit
your account with the refund."
 Debit: an accounting entry on the left or top of a balance sheet. Usually an increase
in assets or a reduction in liabilities. Every debit has a balancing credit.
 Depreciation: an expense that is supposed to reflect the loss in value of a fixed
asset. For example, if a machine will completely wear out after ten year's use, the
cost of the machine is charged as an expense over the ten‐year life rather than all
at once, when the machine is purchased. Straight line depreciation charges the
same amount to expense each year. Accelerated depreciation charges more to
expense in early years, less in later years. Depreciation is an accounting expense.
In real life, the fixed asset may grow in value or it may become worthless long
before the depreciation period ends.
Check Your Progress: Answers

1. (c) Income exceeds Expenditure
2. (a) Credit
3. (a) Receiving of benefits
4. (d) Left or debit side of the account
5. (d) Right or credit side of the account
6. (d) All of the given options
7. (c) Balance Sheet
8. (d) Land
9. (d) Creditors
10. (c) Subtracted from capital
4.10 Further Readings

 Committee on Concepts and Standards Underlying Corporate Financial
Statements. 1952. Current assets and current liabilities: Supplementary statement
No. 3. The Accounting Review (January): 15. (JSTOR link).
Statements. 1954. Accounting corrections: Supplementary Statement No. 5. The
Accounting Review (April): 186-187. (JSTOR link).
Statements. 1954. Inventory pricing and changes in price levels: Supplementary
Statement No. 6. The Accounting Review (April): 188-193. (JSTOR link).
Statements. 1955. Standards of disclosure for published financial reports:
Supplementary statement No. 8. The Accounting Review (July): 400-404. (JSTOR
link).

 Committee on Cost Concepts and Standards. 1956. Tentative statement of cost

concepts underlying reports for management purposes. The Accounting Review
Notes (April): 182-193. (JSTOR link).
 Committee on Foundations of Accounting Measurement: Report. 1971. The
Accounting Review (Supplement): 1+3-48. (JSTOR link). (Committee members are
listed in the front matter). (JSTOR link).

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98 Financial Reporting & Decision Making

Unit 4: Liquidity of Short-term Assets

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Liquidity ratio calculation and analysis

Quick Ratio (Acid Test Ratio)

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Sales to Working Capital (Working Capital Turnover)

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4.2 Financial Ratios: As Perceived by Corporate Controllers

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Profitability or Return on Investment Ratios

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 Return on investment 2: Dividends +/- Stock Price Change/Stock Price Paid—

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 Inventory holding period: 365/Annual Inventory Turnover—calculates the number

Key financial ratio areas

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What each ratio means

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4.2.1 Most significant ratios and their primary measure

Classification of financial ratios on the basis of function

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Some frequently used long-term solvency ratios are given below:

Classification on the basis of financial statements

Income statement/profit and loss ratios

Balance sheet ratios

Classification on the basis of importance

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Market Value Ratios

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4.2.2 Key financial ratios included as Corporate Objectives

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4.2.3 Financial Ratios used in Annual Reports

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General Discussion of Income Statement

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Common-Size Income Statement

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The percentages shown for Example Corporation can be compared to other

Financial Ratios Based on the Income Statement

4.3 Related Debt Paying Ability & Long-term Debt-paying Ability

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Debt ratio calculation and analysis

Times Interest Earned

The Long-Term Debt to Total Capitalization Ratio

Debt to Equity Ratio

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Debt to Tangible Net worth Ratio

4.3.1 Current Assets

BREAKING DOWN 'Current Assets'

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4.3.2 Current liabilities

BREAKING DOWN 'Current Liabilities'

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Examples of Current Liabilities

Accounting for Current Liabilities

4.3.3 The Operating cycle