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A single ratio by itself is not very meaningful. Various comparisons can shed light on the firm’s performance. LO 2 Use ratios to evaluate a company’s liquidity, solvency, and profitability.
ILLUSTRATION 2-9 Financial ratio classificationsRATIO ANALYSISLO 2
•The difference between current assets and current liabilities is referred to as the company’s working capital.•Working capital is the liquid buffer available in meeting financial demands and contingencies of the near future.Working CapitalLIQUIDITY
Current assets - Current liabilities$812,600 - $499,500 = $313,100Working Capital
LIQUIDITY RATIOS•The current ratiois computed by dividing total current assets by total current liabilities.–Current ratio = Current assets/Current liabilities
Current assetsCurrent liabilities$812,600 Current Ratio$499,500= 1.63
LIQUIDITY RATIOS•The quick ratio, also known as theacid-test ratio indicates how well a firm can satisfy existing short-term obligations with assets that can be converted into cash without difficulty.–Quick ratio = (Cash+Securities+Receivables)/Current liabilities
(Cash + Sec. + Rec.)Current liabilities$483,700 $499,500= 0.97Quick Ratio
LEVERAGE/SOLVENCY RATIOS•Comparing the amount of liabilities to the amount of assets held by a business indicates the extent to which borrowed funds have been used to leveragethe owners’ investments and increase the size of the firm.•One frequently used measure of leverage is the debt ratio.
Total liabilitiesTotal assets$1,098,700 $1,952,600= 0.56This company borrowed 56% of the money it needed to buy its assets.Debt Ratio
•To appropriately measure profitability, net income must be compared to some measure of the size of the investment. •Two financial ratios used to assess a firm’s overall profitability are return on assetsand return on equity.Profitability Ratios
Return on AssetsReturn on AssetsNet incomeAverage total assets=$150,000($1,820,450+$1,952,600)/2= 7.95%This means that one dollar of assets generated 7.95 cents in net income.Assume the total assets at the beginning of the period are $ 1,820,450, and net income is $150,000.
Return on EquityReturn on EquityNet incomeAverage stockholders’ equity=$150,000($703,900+$853,900)/2= 19.3%Stockholders earned 19.3 cents for each dollar of equity invested.Assume the stockholders’ equity at the beginning of the period is $ 703,900, and net income is $150,000.
THE INCOME STATEMENT
ELEMENTS OF THE INCOME STATEMENT•Revenues are the increase in assets that result from the sale of products or services. They include: –sales revenue from products or services–interest revenue from investments•Expenses are the cost of resources used to earn revenues during a period. They include:–Cost of goods sold or cost of sales, Selling, general and administrative expenses, Research and development expense, other expense, and Income tax expense
Subtract total expenses from total revenuesTwo reasonsfor using the single-step format: 1.Company does not realize any type of profit or income until total revenues exceed total expenses.