Free Prentice Hall's one-day MBA in finance & accounting by Michael Muckian, Prentice-Hall, inc Page A
their stock shares, a P/E multiple can be used. In the example, the company’s EPS is $3.75 for the most recent year (see Figure 4.1). Suppose you own some of the capital stock shares and someone offers to buy your shares. You could establish an offer price at, say, 12 times basic EPS, which is $45 per share.
The potential buyer may not be willing to pay this price, of course. Or he or she might be willing to pay 15 or even 18
times EPS.
54
Team-Fly®
I N T E R P R E T I N G F I N A N C I A L S T A T E M E N T S
DEBT-PAYING-ABILITY RATIOS
If a business cannot pay its liabilities on time, bad things can happen. Solvency refers to the ability of a business to pay its liabilities when they come due. Maintaining solvency (debt-paying ability) is essential for every business. If a business defaults on its debt obligations it becomes vulnerable to legal proceedings by its lenders that could stop the company in its tracks, or at least seriously interfere with its normal operations.
Therefore, investors and lenders are very interested in the general solvency and debt-paying ability of a business.
Bankers and other lenders, when deciding whether to make and renew loans to a business, direct their attention to certain solvency ratios. These ratios provide a useful profile of the business for assessing its creditworthiness and for judging the ability of the business to pay its loans and interest on time.
Short-Term Solvency Test: The Current Ratio
The current ratio is used to test the short-term liability-paying ability of a business. The current ratio is calculated by dividing total current assets by total current liabilities. From the data in the company’s balance sheet (Figure 4.2), its current ratio is computed as follows:
$12,742,329 current assets
ᎏᎏᎏᎏ = 2.08 current ratio
$6,126,096 current liabilities
The current ratio is hardly ever expressed as a percent (which would be 208 percent in this case). The current ratio is stated as 2.08 to 1.00 for this company, or more simply just as 2.08. The general expectation is that the current ratio for a business should be 2 to 1 or higher. Most businesses find that their creditors expect them to maintain this minimum current ratio. In other words, short-term creditors generally prefer that a business limit its current liabilities to one-half or less of its current assets.
Why do short-term creditors put this limit on a business?
The main reason is to provide a safety cushion for payment of its short-term liabilities. A current ratio of 2 to 1 means there is $2 of cash and assets that should be converted into cash during the near future to pay each $1 of current liabilities that 55
F I N A N C I A L R E P O R T I N G
come due in roughly the same time period. Each dollar of short-term liabilities is backed up with two dollars of cash on hand plus near-term cash inflows. The extra dollar of current assets provides a margin of safety.
In summary, short-term sources of credit generally demand that a company’s current assets be double its current liabilities. After all, creditors are not owners—they don’t share in the profit success of the business. The income on their loans is limited to the interest they charge. As creditors, they quite properly minimize their loan risks; they are not compensated to take on much risk.
Acid Test Ratio, or Quick Ratio
Inventory is many weeks away from conversion into cash.
Products usually are held two, three, or four months before being sold. If sales are made on credit, which is normal when one business sells to another business, there’s a second waiting period before accounts receivables are collected. In short, inventory is not nearly as liquid as accounts receivable; it takes a lot longer to convert inventory into cash. Furthermore, there’s no guarantee that all the products in inventory will be sold, or sold above cost.
A more severe test of the short-term liability-paying ability of a business is the acid
The potential buyer may not be willing to pay this price, of course. Or he or she might be willing to pay 15 or even 18
times EPS.
54
Team-Fly®
I N T E R P R E T I N G F I N A N C I A L S T A T E M E N T S
DEBT-PAYING-ABILITY RATIOS
If a business cannot pay its liabilities on time, bad things can happen. Solvency refers to the ability of a business to pay its liabilities when they come due. Maintaining solvency (debt-paying ability) is essential for every business. If a business defaults on its debt obligations it becomes vulnerable to legal proceedings by its lenders that could stop the company in its tracks, or at least seriously interfere with its normal operations.
Therefore, investors and lenders are very interested in the general solvency and debt-paying ability of a business.
Bankers and other lenders, when deciding whether to make and renew loans to a business, direct their attention to certain solvency ratios. These ratios provide a useful profile of the business for assessing its creditworthiness and for judging the ability of the business to pay its loans and interest on time.
Short-Term Solvency Test: The Current Ratio
The current ratio is used to test the short-term liability-paying ability of a business. The current ratio is calculated by dividing total current assets by total current liabilities. From the data in the company’s balance sheet (Figure 4.2), its current ratio is computed as follows:
$12,742,329 current assets
ᎏᎏᎏᎏ = 2.08 current ratio
$6,126,096 current liabilities
The current ratio is hardly ever expressed as a percent (which would be 208 percent in this case). The current ratio is stated as 2.08 to 1.00 for this company, or more simply just as 2.08. The general expectation is that the current ratio for a business should be 2 to 1 or higher. Most businesses find that their creditors expect them to maintain this minimum current ratio. In other words, short-term creditors generally prefer that a business limit its current liabilities to one-half or less of its current assets.
Why do short-term creditors put this limit on a business?
The main reason is to provide a safety cushion for payment of its short-term liabilities. A current ratio of 2 to 1 means there is $2 of cash and assets that should be converted into cash during the near future to pay each $1 of current liabilities that 55
F I N A N C I A L R E P O R T I N G
come due in roughly the same time period. Each dollar of short-term liabilities is backed up with two dollars of cash on hand plus near-term cash inflows. The extra dollar of current assets provides a margin of safety.
In summary, short-term sources of credit generally demand that a company’s current assets be double its current liabilities. After all, creditors are not owners—they don’t share in the profit success of the business. The income on their loans is limited to the interest they charge. As creditors, they quite properly minimize their loan risks; they are not compensated to take on much risk.
Acid Test Ratio, or Quick Ratio
Inventory is many weeks away from conversion into cash.
Products usually are held two, three, or four months before being sold. If sales are made on credit, which is normal when one business sells to another business, there’s a second waiting period before accounts receivables are collected. In short, inventory is not nearly as liquid as accounts receivable; it takes a lot longer to convert inventory into cash. Furthermore, there’s no guarantee that all the products in inventory will be sold, or sold above cost.
A more severe test of the short-term liability-paying ability of a business is the acid
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