4 Common Liquidity Ratios in Accounting

4 Common Liquidity Ratios in AccountingOne way a business can manage its books and viability in the near and long terms is to see how liquid its assets are. Businesses that have better cash positions are naturally geared toward sustaining continued success. One important reason for a business to measure and maintain healthy levels of liquidity is because it promotes better odds that a company will be able to satisfy its short-term debts. There are many ways a business can accomplish this, and below are four common ways it can be done.  

Current Ratio

One of the few liquidity ratios is what’s known as the current ratio. It’s a way to determine how well a company can pay back its debts.

The current ratio is also known as the “working capital ratio,” showing how well a business can satisfy financial obligations that must be paid back within 12 months. Using an example is a good way to see how it works:

Let’s assume a company has the following assets, it would use the following ratio:

Current Ratio = Current Assets / Current Liabilities

Marketable Securities such as stocks, bonds or purchase agreements maturing in 12 months or less can be considered a current asset. Businesses may also consider cash, accounts receivable, prepaid expenses, office supplies and saleable inventory they have in stock as current assets.

Outstanding bills or accounts payable and short-term debt – within the next 12 months as described above – are considered current liabilities. Other expenses can be interest payable, income and payroll taxes payable, which can also be considered current liabilities.

If the current assets of a business are $250 million, and that is divided by current liabilities of $75 million, the Current Ratio would be 250 / 75, or 3.33

With a current ratio of 3.33, the company is in good financial health because it can pay off its debts easily.

Acid-Test Ratio

The Acid-Test Ratio determines how capable a company is of paying off its short-term liabilities with assets easily convertible to cash.

Also known as the quick ratio, the formula is as follows:

Acid-Test Ratio = Current Assets – Inventories / Current Liabilities

Current assets consist of cash and similar assets (savings/checking accounts, deposits becoming liquid in three months or less), marketable securities and accounts receivable. From there, the summation is divided by the company’s current liabilities expected to be paid in 12 months.

The other way to calculate the acid-test ratio or quick ratio is as follows:

The first step is to look at the company’s current assets that can be liquidated within 12 months. Then inventory must be valued – that which is intended to be sold for purchase. From there, the inventory value is subtracted from the current assets. The resulting value is then divided by the business’ current liabilities.

The acid-test ratio is one way to determine a company’s ability to satisfy current liabilities without selling inventory or getting more lending. With the uncertainty and profitability of selling inventory, one can argue that it gives a better picture of a company’s financial fitness.   

For example, if a company comes out with a ratio of 3, this means that a business has $3 for every $1 of liabilities. However, as a company’s quick ratio increases, it might show there’s too much money not being reinvested to increase the company’s efficiency and profitability. A higher quick ratio figure can also indicate that there are too many accounts receivable that are owed but uncollected by the company.

Cash Ratio

As the name implies, the cash ratio determines how financially able a company is to satisfy short-term liabilities with cash and cash equivalents.

Also referred to as the cash asset ratio, this tells how capable a business is of satisfying short-term debts, usually 12 months or less, with cash and cash equivalents only. This ratio is as follows:

Cash Ratio = Cash and Cash Equivalents / Current Liabilities

Examples of cash and cash equivalents include physical currency, minted coins, and checks. Cash equivalents include money market accounts, Treasury bills and anything that can be converted into cash in almost real-time.

When it comes to current liabilities, accrued liabilities, short-term debts and accounts payable are examples that are due within one year.      

From there, the ratio is as follows to determine a company’s cash asset ratio:

Cash and Cash Equivalents (Cash: $25,000 + Cash Equivalents: $100,000) / Liabilities (Accounts Payable: $30,000 + Short-term debt: $25,000)

$125,000 / $55,000 = 2.27

Based on this calculation, the company would be able to pay off 227 percent of present liabilities with its cash and/or cash equivalents. For creditors and investors evaluating a company, it can show the company has ample liquidity. Creditors are naturally more willing to lend to companies with more cash flow; and investors are interested to see how liquidity is being managed.

Operating Cash Flow Ratio

This ratio measures how efficiently a business can meet present liabilities from the cash flow of its core business operations. It tells a company the number of times over it can satisfy its liabilities based on the amount of cash it generated over a certain time-frame.

This ratio can also include accruals, giving a fair estimate of a business’s short-term liquidity. The formula to determine this ratio is as follows:

Operating Cash Flow Ratio = Cash Flow from Operations / Current Liabilities

The statement of cash flow is where the operation’s cash flow is found. It can also be calculated by determining a company’s net income, plus non-cash expenses, plus working capital changes.

Current liabilities are defined as financial obligations due within the next 12 months. Common ones are accrued liabilities, accounts payable and/or short-term debt.

Once the operating cash flow ratio is calculated, a company’s financial health can be determined. If the ratio is 1.5 or 2, for example, it means the company can cover 1.5 times or double its present liabilities. However, if the ratio is less than 1, then the amount of cash generated from operations is insufficient to satisfy short-term liabilities.

As part of a comprehensive accounting practice, businesses that run these ratio calculations will be able to identify where there’s too little or too much liquidity and reduce current and future financial peril.

How to Calculate and Analyze Return on Equity

How to Calculate and Analyze Return on EquityWhen it comes to evaluating a business, especially one that is publicly traded, determining its return on equity (ROE) is one way to see how it’s performing.

What is Return on Equity?

Return on equity is a ratio that gives investors insight into how effectively the company’s management team is taking care of the shareholders’ financial investments in the company. The greater the ROE percentage, the better the business’ management staff is at making income and creating growth from shareholders’ investments.  

How ROE is Determined

In order to calculate ROE, a company’s net income is divided by shareholder equity. To arrive at net income, businesses account for the cost of doing business, which includes the cost of goods sold, sales, operating and general expenses, interest, tax payments, etc. and then subtracts these costs of doing business from all sales. Similarly, the free cash flow figure can be substituted in place of net income.

There are some caveats when it comes to calculating net income. It is determined prior to paying out dividends to common shareholders, but loan interest and preferred shareholder dividend obligations must be met before starting this calculation.

The other part of the equation is the shareholder equity or stockholders’ equity. One definition is to subtract existing liabilities from a business’ assets, and what remains is what owners of a corporation or its shareholders would be able to claim as their equity in the company. Whether it’s done year over year or quarter over quarter, traders and investors can see how well a company performs over different time periods.

Return on equity is also able to be determined if a business’ net income and equity are in the black. The net income is found on the income statement – the ledger of the company’s financial transactions. Shareholders’ equity is found on the balance sheet – which details the business’ assets and financial obligations.

Analyzing a Business’ ROE

Another consideration that industry experts recommend to determine if a company’s ROE is poor or excellent is to see how it compares to the S&P 500 Index’s performance. With the historical rate of return being 10 percent annually over the past decade, and if a ROE is lower than 10 percent, it can give a good indication as to a particular business’ performance. However, a particular company’s ROE also needs to be compared against the industry’s ROE to see if the company is outperforming its sector.

For example, according to Yahoo Finance!, the ROE on Microsoft’s stock is 42.80 percent. This means that the management team running Microsoft is returning just shy of 43 cents for every dollar in shareholders’ equity. Compared to its industry (Software System & Application) ROE of 13.47percent – as cited by New York University’s Stern School of Business – Microsoft has a much higher ROE compared to the industry average. This is just one metric to measure the company’s performance, but it is an important one.

While looking at a company’s return on equity is not the end all or be all, it’s a good start to determine a company’s present and future financial health.

Sources

https://us.spindices.com/indices/equity/sp-500

https://finance.yahoo.com/quote/MSFT/key-statistics?p=MSFT

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/roe.html

Furniture, Fixtures and Equipment – and Depreciation

When it comes to determining depreciation for Furniture, Fixtures and Equipment (FF&E), there are many considerations that exist for accountants and business owners.

Defining Furniture, Fixtures and Equipment

FF&E refers to expenses for business items that are not affixed to the building where that business operates. Real world examples of depreciable assets includes chairs, desks, phones, tables, cabinets, etc., which are used to perform business-related tasks, directly or indirectly. These types of items are associated with long-term use generally more than 12 months, according to the Internal Revenue Service.

Understanding How It Works

When it comes to accounting for the expense of the item, it can be depreciated equally and discreetly over its useful life. According to the IRS’ General Depreciation System (GDS), these office items such as safes, desks and files, are expected to have a seven-year life.

While there are different approaches to calculate depreciation, a common way to do so is through straight-line depreciation. This method is used by many organizations, including The Federal Reserve, and it works by starting with how much the item cost to acquire or its adjusted basis. From there, the item’s cost is reduced by the salvage value, or the asset’s value after its useful life. The resulting figure is divided by the number of months of the asset’s useful life. Once the asset has exhausted this amount of time, it remains on the books as its salvage value until it’s sold or removed from service.

Using the straight-line method, a company might find the monthly depreciation charge for a truck purchase like this. The company purchases a new truck for $40,000; assuming a 60-month useful life allowable by the IRS and a 20 percent salvage value, the formula would be as follows:

  1. $40,000 – (20 percent x $40,000) / 60 months
  2. $40,000 – ($8,000) / 60 months
  3. $32,000 / 60 = $533.33 per month for monthly depreciation

Special Considerations

In addition to tangible property, some intangible property also can be depreciated under the right circumstances. Examples the IRS cites of this primarily intellectual property includes copyrights, patents and software. Conditions for depreciation of this type of intangible property include that it must be owned by the business owner, used within the business or for profit-related activities, have a useful life and can be used by the business for more than a year.

The IRS gives an example of an individual buying a patent for $5,100. Using the straight-line method, the IRS permits this type of non-section 197 intangible property to be depreciated under certain conditions. The owner then must reduce any salvage value from the non-section 197 intangible property’s adjusted basis and depreciate it over the patent’s useful life, prorating terms less than a year, if applicable.  

Eligible Intangible Property Example

Assume the individual bought a patent in May to be used starting June 1 of the same year. The patent was bought for $5,100, has a 17-year useful life and won’t have any salvage value.

The first year of depreciation must be prorated for six months, since it will be used from June to December of the first year. Taking these circumstances and rules from the IRS, the first year’s depreciation available is $150. Each subsequent year, the 16 remaining will be $300 each.

While there are many intricacies for depreciation, understanding how it applies to each business’ operations will help give a fair assessment of an equipment’s value.

Sources

https://www.irs.gov/pub/irs-pdf/p946.pdf