Generally, businesses do not provide their current ratio on the face of their balance sheets or in the footnotes to their financial statements — they leave it to the reader to calculate this number. On the other hand, many businesses present a financial highlights section in their financial report, which often includes the current ratio.
The quick ratio is more restrictive. Only cash and assets that can be immediately converted into cash are included, which excludes accounts receivable, inventory, and prepaid expenses. The business in our example does not have any short-term marketable investments that could be sold on a moment’s notice. So, only cash is included for the ratio. You compute the quick ratio as follows (refer to Figure 5-1):
$2,165,000 quick assets ÷ $4,030,000 current liabilities = .54 quick ratio
Folklore has it that a company’s current ratio should be at least 2.0 and its quick ratio 1.0. However, business managers know that acceptable ratios depend a great deal on general practices in the industry for short-term borrowing. Some businesses do well with current ratios less than 2.0 and quick ratios less than 1.0, so take these benchmarks with a grain of salt.
Lower ratios do not necessarily mean that the business won’t be able to pay its short-term (current) liabilities on time. Chapters 13 and 16 explain
solvency in more detail.
the Balance Sheet
A balance sheet is a snapshot of the financial condition of a
business at an instant in time — the most important moment in time being at the end of the last day of the income statement period. If you read
Chapter 4, you noticed that I continue using the same example in this chapter. The fiscal, or accounting, year of the business ends on December 31. So its balance sheet is prepared at the close of business at midnight December 31. (A company should end its fiscal year at the close of its natural business year or at the close of a calendar quarter — September 30, for example.) This freeze-frame nature of a balance sheet may make it appear that a balance sheet is static. Nothing is further from the truth. A business does not shut down to prepare its balance sheet. The financial condition of a business is in constant motion because the activities of the business go on nonstop.
Transactions change the makeup of a company’s balance sheet — that is, its assets, liabilities, and owners’ equity. The transactions of a business fall into three basic types:
Operating activities, which also can be called profit-making
activities: This category refers to making sales and incurring expenses, and also includes accompanying transactions that lead or follow the recording of sales and expenses. For example, a business records sales revenue when sales are made on credit, and then, later, records cash collections from customers. The transaction of collecting cash is the indispensable follow-up to making the sale on credit. For another example, a business purchases products that are placed in its inventory (its stock of products awaiting sale), at which time it records an entry for the purchase. The expense (the cost of goods sold) is not recorded until the products are actually sold to customers. Keep in mind that the term operating activities includes the associated transactions that precede or are subsequent to the recording of sales and expense transactions.
Investing activities: This term refers to making investments in assets and (eventually) disposing of the assets when the business no longer needs them. The primary examples of investing activities for businesses that sell products and services are capital expenditures, which are the amounts spent to modernize, expand, and replace the long-term operating assets of a
business. A business may also invest in financial assets, such as bonds and stocks or other types of debt and equity instruments. Purchases and sales of financial assets are also included in this category of transactions.
Financing activities: These activities include securing money from debt and equity sources of capital, returning capital to these sources, and making distributions from profit to owners. Note that distributing profit to owners is treated as a financing transaction. For instance when a business corporation pays cash dividends to its stockholders the distribution is treated as a
financing transaction. The decision whether or not to distribute some of its profit depends on whether the business needs more capital from its owners, to grow the business or to strengthen its solvency. Retaining part or all of profit for the year is one way of increasing the owner’s equity in the
business. I discuss this topic later in the chapter (see “Financing a Business:
Sources of Cash and Capital” later in the chapter).
Figure 5-2 presents a summary of changes in assets, liabilities, and owners’
equity during the year for the business example I introduce in Chapter 4.
Notice the middle three columns in Figure 5-2, for each of the three basic types of transactions of a business. One column is for changes caused by its revenue and expenses and their connected transactions during the year, which collectively are called operating activities (although I prefer to call them profit-making activities). The second column is for changes caused by its investing activities during the year. The third column is for the changes caused by its financing activities.
Note: Figure 5-2 does not include subtotals for current assets and liabilities.
(The formal balance sheet for this business is presented in Figure 5-1).
Businesses do not report a summary of changes in their assets, liabilities, and owners’ equity such as Figure 5-2. (Personally I think that such a summary would be helpful to users of financial reports.) The purpose of Figure 5-2 is to demonstrate how the three major types of transactions
during the year change the assets, liabilities, and owner’s equity accounts of the business during the year.
The 2013 income statement of the business is shown in Figure 4-1 in Chapter 4. You may want to flip back to this financial statement. On sales revenue of $26 million, the business earned $1.69 million bottomline profit (net income) for the year. The sales and expense transactions of the
business during the year plus the associated transactions connected with sales and expenses cause the changes shown in the operating activities column in Figure 5-2. You can see in Figure 5-2 that the $1.69 million net
income has increased the business’s owners’ equity–retained earnings by the same amount.
The operating activities column in Figure 5-2 is worth lingering over for a few moments because the financial outcomes of making profit are seen in this column. In my experience, most people see a profit number, such as the $1.69 million in this example, and stop thinking any further about the financial outcomes of making the profit. This is like going to a movie because you like its title, but you don’t know anything about the plot and characters. You probably noticed that the $1,515,000 increase in cash in this column differs from the $1,690,000 net income figure for the year. The cash effect of making profit (which includes the associated transactions connected with sales and expenses) is almost always different than the net income amount for the year. Chapter 6 on cash flows explains this
difference.
Figure 5-2: Summary of changes in assets, liabilities, and owners’ equity during the year according to basic types of transactions.
The summary of changes presented in Figure 5-2 gives a sense of the
balance sheet in motion, or how the business got from the start of the year to the end of the year. It’s very important to have a good sense of how transactions propel the balance sheet. A summary of balance sheet changes, such as shown in Figure 5-2, can be helpful to business managers who plan and control changes in the assets and liabilities of the business. They need a clear understanding of how the three basic types of transactions change assets and liabilities. Also, Figure 5-2 provides a useful platform for the statement of cash flows, which I explain in Chapter 6.
Coupling the Income Statement and Balance Sheet
Chapter 4 explains that sales and expense transactions change certain assets and liabilities of a business. (These changes are summarized in Figure 5-2.) Even in the relatively straightforward business example introduced in
Chapter 4, we see that cash and four other assets are involved, and three liabilities are involved in the profit-making activities of a business. I explore these key interconnections between revenue and expenses and the assets and liabilities of a business here. It turns out that the profit-making activities of a business shape a large part of its balance sheet.
Figure 5-3 shows the vital links between sales revenue and expenses and the assets and liabilities that are driven by these profit-seeking activities.
Note that I do not include cash in Figure 5-3. Sooner or later, sales and expenses flow through cash; cash is the pivotal asset of every business.
Chapter 6 examines cash flows and the financial statement that reports the cash flows of a business. Here I focus on the noncash assets of a business, as well as its liabilities and owners’ equity accounts that are directly
affected by sales and expenses. You may be anxious to examine cash flows, but as we say in Iowa, “Hold your horses.” I’ll get to cash in Chapter 6.
The income statement in Figure 5-3 continues the same business example I introduce in Chapter 4. It’s the same income statement but with one
modification. Notice that the depreciation expense for the year is pulled out of selling, general, and administrative expenses. We need to see
depreciation expense on a separate line.
Figure 5-3 highlights the key connections between particular assets and liabilities and sales revenue and expenses. Business managers need a
good understanding of these connections to control assets and liabilities.
And outside investors and creditors should understand these connections to interpret the financial statements of a business (see Chapters 13 and 16).
Figure 5-3: The connections between sales revenue and expenses and the noncash assets, liabilities, and owners’ equity driven by these profit-making activities.