Accounting 101 – Financial Statement Analysis

Liquidity Ratio Analysis Balance Sheet Assets and Liabilities

Oct 24, 2009

Ratio analysis of the financial statements is used to measure company performance. Learn various ratio analyses of the income statement and balance sheet.

Investors and lending institutions will often use ratio analyses of the financial statements to determine a company’s profitability and liquidity. If the ratios indicate poor performance, investors may be reluctant to invest. Lending institutions make be reluctant to extend an open line of credit. Financial statement ratio analysis also allows the entrepreneur to track trends to make sure that the company is headed in the right direction.

Asset and Liabilities Liquidity Ratios

Liquidity ratios measure the company’s ability to meet its short-term debt obligations. Short-term debts are payments that are due in the very new future. Payments to vendors in accounts payable and notes payable are some examples of short-term debt obligations. Liquidity ratios are also a measurement of the company’s ready cash position. The balance sheet is used to calculate liquidity ratios.

Balance Sheet Current Ratio

The current ratio or working capital ratio, measures current assets against current liabilities. The current ratio measures the company’s ability to pay back its short-term debt obligations with its current assets. A higher ratio indicates the company is better equipped to pay off short-term debt with current assets.

Balance Sheet Acid Test Ratio

The acid test ratio or quick ratio, measures quick assets against current liabilities. Quick assets are considered assets that can be quickly converted into cash. Generally they are current assets less inventory. Common examples of quick assets are cash, accounts receivable and short-term investments. A ratio of less than 1.0 may indicated a serious problem of the company’s ability to pay its short-term debt obligations.

Asset Management and Inventory Turnover Ratio

Inventory turnover ratio measures the movement of inventory. It shows how many times the inventory is sold within a specific period of time. There are different methods of calculating inventory turnover. One method is to show how many times the inventory moves (or turns) within a one-year period.

As an example if a company has a total cost of sale in the last 12 months of $120,000 and has $20,000 in inventory at the end of the month, the current inventory turns 6.0 times (120,000/20,000).

Asset Management and Accounts Receivable Turn Over

Receivables turn over measures the company’s ability to make good credit decisions. It also shows the ability to collect debt from customers. Companies that have a poor receivables turn over ratio either make poor credit decisions, do a poor job of tracking receivables or both.

Current liquidity ratios should be compared with previous ratios. Look for negative trends that may be developing. Find out what the average liquidity ratios are within the same industry for comparison. If other companies within the same industry have better numbers, this could indicate a competitive advantage.

The copyright of the article Accounting 101 – Financial Statement Analysis in Financial Statements is owned by James Clausen. Permission to republish Accounting 101 – Financial Statement Analysis in print or online must be granted by the author in writing.