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Power of Analyzing Financial Statements To Improve the Financial Condition of Your Business - Jul 2, 2010

Posted by: Charles G. Yacoobian in Articles

Let’s review some key analytical tools to aid you in maximizing the success of your business.

Working Capital/Current Ratio Of primary concern to all parties is the solvency – the ability of the business to meet its current (those due within one year) obligations. Basic accounting equation: Working Capital = Current Assets – Current Liabilities. Accordingly, assets and liabilities are generally divided and classified as (1) current or short-term items and (2) noncurrent or long-term and (3) fixed assets/equipment/machinery.

Examples of Current Assets (assets that will turn into cash or offset liabilities within one year):

Cash and short-term investments/marketable securities
Accounts Receivable
Inventory
Prepaid Expenses

Examples of Current Liabilities (amounts that are due to be paid within one year):

Accounts Payable
Portion of LT debt due within the next twelve months
Accrued liabilities (taxes, payroll, other expenses, etc.)

A business should have a minimum Current Ratio of 1:1…in other words, Current Assets equal Current Liabilities. A Current Ratio of 2:1 or higher is preferred.

Other Ratios and Earnings Tests

Acid-Test Ratio – Inventory of raw materials, work in progress and finished goods (or merchandise) often represent a large portion of total current assets. A considerable amount of time may be required to convert inventories into cash in the normal operating process. There is also the possibility of declines in market prices and a reduction in demand, both of which will adversely affect the ability to pay current liabilities. The acid-test ratio gives recognition to these factors. It is the ratio of the sum of cash, receivables and marketable securities, which are sometimes called quick assets, to current liabilities. Although there is no definite standard, an acid-test ratio in excess of 1:1 is usually considered to be satisfactory:

2010 2009

Quick Assets:

Cash $ 90,500 $ 51,000
Marketable Securities 75,000 75,000
Receivables (net) 115,000 120,000

Total $280,500 $246,000

Current Liabilities $210,000 $243,000

Acid-Test Ratio 1.3:1 1.0:1

Ratio of Sales to Assets – A measure of the effectiveness of the utilization of assets. Assume that two competing firms have equal amounts of assets, but that one company has double the sales of the other firm. The company with the larger sales is making better use of its assets.

Rate Earned on Total Assets – It is the measure of productivity of the assets, without regard to the equity of the creditors and stockholders in the assets. Therefore, the rate is not affected by differences in methods of financing a business.

Rate Earned on Stockholders’ Equity – This measure emphasizes the income yield in relationship to the amount invested by the stockholders, including initial investment and retained earnings.

Ratio of Owners’ Equity to Liabilities – Claims against the total assets of a business are divided into two basic groups, those of the creditors and those of the owners. The relationship between the total claims of the two groups provides an indication of the margin of safety of the creditors and the ability of the business to withstand adverse business conditions. If the claims of creditors are large in proportion to the equity of the owners, there are likely to be substantial charges for interest payments. If earnings decline to the point of inability to meet interest payments, control of the business may pass to the creditors.