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GLENCOE / McGraw-Hill

GLENCOE / McGraw-Hill. Statement Analysis: Measuring Profitability, Financial Strength, and Liquidity. Ratios Measuring Liquidity. Section Objectives. Compute and interpret financial ratios that measure liquidity. Recognize shortcomings in financial statement analysis. QUESTION:.

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GLENCOE / McGraw-Hill

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  1. GLENCOE / McGraw-Hill

  2. Statement Analysis: Measuring Profitability, Financial Strength, and Liquidity

  3. Ratios Measuring Liquidity Section Objectives • Compute and interpret financial ratios that measure liquidity. • Recognize shortcomings in financial statement analysis.

  4. QUESTION: What is liquidity? ANSWER: Liquidity is a measure of the ability of a business to pay its debts when due. Page 888

  5. Working capital Current ratio Acid-test ratio Inventory turnover Accounts receivable turnover Page 888 Ratios Measuring Liquidity

  6. Measures the ability of a company to meet its current obligations Formula: Current assets – Current liabilities Working capital $386,599 –40,905 $345,694 Page 888 Working Capital • Example:

  7. Measures the ability of a business to pay its debts using current assets Formula: $386,599 = 9.45:1 $ 40,905 Page 888 Current Ratio Current assets ÷ Current liabilities = Current ratio • Example: In retail and manufacturing businesses, a popularguideline is a current ratio of at least 2 to 1.

  8. Measures immediate liquidity Formula: • Cash $100,754 • Receivables 92,300 • Marketable securities – 0 – • $193,054 $193,054 $ 40,905 = 4.72:1 Page 889 Acid-Test Ratio Quick assets ÷ Current liabilities = Acid-test ratio Quick assets are cash, receivables, and marketable securities. • Example: A general guideline is that the acid-test ratio should be at least 1 to 1.

  9. Measures the number of times the inventory is replaced during the period Formula: Page 889 Inventory Turnover Cost of goods sold ÷ Average inventory = Inventory turnover • Procedure: • Step 1: Compute the average inventory. • Step 2: Divide the cost of goods sold by the average inventory.

  10. Step 1: Compute the average inventory. Inventory, Dec. 31 192,500 ÷ 2 Average inventory $ 208,750 Page 889 Inventory Turnover Inventory, Jan. 1 $ 225,000 Totals $ 417,500

  11. Step 1: Average inventory = $208,750 $1,764,598 $ 208,750 = 8.45 times Page 890 Inventory Turnover • Step 2: Divide the cost of goods sold by the average inventory. The inventory turnover ratio varies widely by industry.

  12. Measures the speed with which sales on account are collected. Formula: Page 890 Accounts Receivable Turnover Net credit sales ÷ Average receivables = Accounts receivable turnover • Procedure: • Step 1: Compute average accounts receivable. • Step 2: Divide net credit sales by average accounts receivable.

  13. Step 1: Compute average accounts receivable. Accounts receivable, Dec. 31 92,300 ÷ 2 Average accounts receivable$ 82,900 Page 890 Accounts Receivable Turnover Accounts receivable, Jan.1 $ 73,500 Totals $165,800

  14. Step 1:Average accounts receivable = $82,900 $1,900,000 $ 82,900 = 22.9 times Page 890 Accounts Receivable Turnover • Step 2: Divide net credit sales by average accounts receivable. The accounts receivable turnover can be used to determine the average collectionperiod of accounts receivable.

  15. QUESTION: What is the average collection period? ANSWER: The average collection period is the number of days’ sales in receivables. 365 days Accounts receivable turnover Average collection period Formula: = Page 890

  16. Financial statements use book values. Book value depends on accounting policies and procedures. Businesses have choices about certain things, such as depreciation methods and useful lives. Financial statements assume that the dollar is a stable monetary unit. No two companies are exactly the same: Different legal entities Different product mixes Different financing methods Page 891 Precautionary Notes on Statement Analysis Financial statement analysis is useful only if these limitations are understood.

  17. R E V I E W Complete the following sentences: Liquidity ________ is a measure of the ability of a business to pay its debts when due. acid-test ratio The formula for the ____________ is quick assets divided by current liabilities. cash receivables Quick assets consist of ____, __________, and ___________________. marketable securities

  18. R E V I E W Complete the following sentences: inventory turnover The formula for ________________ is cost of goods sold divided by average merchandise inventory. The formula for accounts receivable turnover is _____________ divided by __________________. net credit sales average receivables average collection period The ______________________ is 365 days divided by the accounts receivable turnover.

  19. Thank You for using College Accounting, Tenth Edition Price • Haddock • Brock

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