Shared Flashcard Set


Financial Statement Analysis
Applications to analyze financial statements

Additional Accounting Flashcards





Liquid assets are those that can be converted into cash quickly. The short-term liquidity ratios show the firm's ability to meet its short-term obligations.

Rule of Thumb

2:1 Current ratio: Total Current assets/Total Current liabities

1:1 Quick ratio: Total current assets-Inventories/Total current liabilities

(Inventories are the least current of the current assets)




Working Capital

What Does Working Capital Mean?
A measure of both a company's efficiency and its short-term financial health. The working capital ratio is calculated as:
[image]Positive working capital means that the company is able to pay off its short-term liabilities. Negative working capital means that a company currently is unable to meet its short-term liabilities with its current assets (cash, accounts receivable and inventory).

Also known as "net working capital", or the "working capital ratio".
If a company's current assets do not exceed its current liabilities, then it may run into trouble paying back creditors in the short term. The worst-case scenario is bankruptcy. A declining working capital ratio over a longer time period could also be a red flag that warrants further analysis. For example, it could be that the company's sales volumes are decreasing and, as a result, its accounts receivables number continues to get smaller and smaller.
Analyzing Debt

Debt ratios show the extent to which a firm is relying on debt to finance its investments and operations, and how well it can manage the debt obligation, i.e. repayment of principal and periodic interest.  If the company is unable to pay its debt, it will be forced into bankruptcy. On the positive side, use of debt is beneficial as it provides tax benefits to the firm, and allows it to exploit business opportunities and grow.

Note that total debt includes short-term debt (bank advances + the current portion of long-term debt) and long-term debt (bonds, leases, notes payable).

1.  Leverage Ratios

1a.   Debt to Equity Ratio = Total Debt / Total Equity

This shows the firm’s degree of leverage, or its reliance on external debt for financing.

1b.  Debt to Assets Ratio = Total Debt  /  Total assets

Some analysts prefer to use this ratio, which also shows the company’s reliance on external sources for financing its assets. 

In general, with either of the above ratios, the lower the ratio, the more conservative (and probably safer) the company is.  However, if a company is not using debt, it may be foregoing investment and growth opportunities.  This is a question that can be answered only by further company and industry research.

A frequently cited rule of thumb for manufacturing and other non-financial industries is that companies not finance more than 50% of their capital through external debt.


Return On Investment - ROI

What Does Return On Investment - ROI Mean?
A performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. To calculate ROI, the benefit (return) of an investment is divided by the cost of the investment; the result is expressed as a percentage or a ratio. 

The return on investment formula:

Return on investment is a very popular metric because of its versatility and simplicity. That is, if an investment does not have a positive ROI, or if there are other opportunities with a higher ROI, then the investment should be not be undertaken.
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