Financial Report Analysis (NUR RAHMAH)

ENGLISH FOR ACCOUNTING

FINAL TEST

BY:

NUR RAHMAH

361 10 042

3B-D3

ACCOUNTING DEPARTMENT

POLITEKNIK NEGERI UJUNG PANDANG

MAKASSAR

2013

A.   Financial Ratio Analysis

Financial ratio analysis involves calculating certain standardized relationship between figures appearing in the financial statements and then using those relationships called ratios to analyze the business' financial position and financial performance.

Due to varying size of businesses different comparison of two businesses is not possible. Certain techniques have to be applied in simplifying the financial statements and making them comparable. These include financial ratio analysis and common-size financial statements.

Ratios are divided into different categories such as liquidity ratios, profitability ratios, etc.

B.   Categories of Financial Ratios

1)      Liquidity Ratios

Liquidity is the ability of a business to pay its current liabilities using its current assets. Information about liquidity of a company is relevant to its creditors, employees, banks, etc. current ratio, quick ratio, cash ratio and cash conversion cycle are key measures of liquidity.

2)      Solvency Ratios

Solvency is a measure of the long-term financial viability of a business which means its ability to pay off its long-term obligations such as bank loans, bonds payable, etc.. Information about solvency is critical for banks, employees, owners, bond holders, institutional investors, government, etc.. Key solvency ratios are debt to equity ratio, debt to capital ratio, debt to assets ratio, times interest earned ratio, fixed charge coverage ratio, etc.

3)      Profitability Ratios

Profitability is the ability of a business to earn profit for its owners. While liquidity ratios and solvency ratios are relationships that explain the financial position of a business profitability ratios are relationships that explain the financial performance of a business. Key profitability ratios include net profit margin, gross profit margin, operating profit margin, return on assets, return on capital, return on equity, etc.

4)      Activity ratios

Activity ratios explain the level of efficiency of a business. Key activity ratios include inventory turnover, days sales in inventory, accounts receivable turnover, days sales in receivables, etc.

Performance ratios include cash flows to revenue ratio, cash flows per share ratio, cash return on assets, etc. and they aim at determining the quality of earnings.

5)      Coverage Ratios

Coverage ratios are supplementary to solvency and liquidity ratios and measure the risk inherent in lending to the business in long-term. They include debt coverage ratio, interest coverage ratio (also known as times interest earned), reinvestment ratio, etc.

Quick ratio or Acid Test ratio is the ratio of the sum of cash and cash equivalents, marketable securities and accounts receivable to the current liabilities of a business. It measures the ability of a company to pay its debts by using its cash and near cash current assets (i.e. accounts receivable and marketable securities).

C.   Formula

Quick ratio is calculated using the following formula:

Quick Ratio
=	Cash + Marketable Securities + Receivables
	Current Liabilities

Marketable securities are those securities which can be coverted into cash quickly. Examples of marketable securities are treasury bills, saving bills, shares of stock-exchange, etc. Receivables refer to accounts receivable. Alternatively, quick ratio can also be calculated using the following formula:

Quick Ratio
=	Current Assets − Inventory − Prepayments
	Current Liabilities

D.   Example

Example 1: A company has following assets and liabilities at the year ended December 31, 2009:

Cash	$34,390
Marketable Securities	12,000
Accounts Receivable	56,200
Prepaid Insurance	9,000
Total Current Assets	111,590
Total Current Liabilities	73,780

Calculate quick ratio (acid test ratio).

Solution
Quick ratio = ( 34,390 + 12,000 + 56,200 ) / 73,780 = 102,590 / 73,780 = 1.39
   OR
Quick ratio = ( 111,590 − 9,000 ) / 73,780 = 102,590 / 73,780 = 1.39

Example 2: Calculate quick ratio from the following information:

Cash	$21,720
Treasury Bills	18,500
Accounts Receivable	15,930
Prepaid Rent	6,500
Inventory	17,240
Total Current Assets	79,890
Total Current Liabilities	52,960

Solution
In this example, treasury bills are marketable securities thus we will calculate quick ratio as follows:
Quick ratio = ( 79,890 − 6,500 − 17,240 ) / 52,960 = 56,150 / 52,960 = 1.06
   OR
Quick ratio = ( 21,720 + 18,500 + 15,930 ) / 52,960 = 56,150 / 52,960 = 1.06

E.   Analysis

Quick ratio measures the liquidity of a business by matching its cash and near cash current assets with its total liabilities. It helps us to determine whether a business would be able to pay off all its debts by using its most liquid assets (i.e. cash, marketable securities and accounts receivable).

A quick ratio of 1.00 means that the most liquid assets of a business are equal to its total debts and the business will just manage to repay all its debts by using its cash, marketable securities and accounts receivable. A quick ratio of more than one indicates that the most liquid assets of a business exceed its total debts. On the opposite side, a quick ratio of less than one indicates that a business would not be able to repay all its debts by using its most liquid assets.

Thus we conclude that, generally, a higher quick ratio is preferable because it means greater liquidity. However a quick ratio which is quite high, say 4.00, is not favorable to a business as whole because this means that the business has idle current assets which could have been used to create additional projects thus increasing profits. In other words, very high value of quick ratio may indicate inefficiency.