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test ratio, which excludes inventory (and prepaid expenses also). Only cash, marketable securities investments (if the business has any), and accounts receivable are counted as sources available to pay the current liabilities of the business. This ratio is also called the quick ratio because only cash and assets quickly convertible into cash are included in the amount available for paying current liabilities.
    The example company’s acid test ratio is calculated as follows (the business has no investments in marketable securities):
    $2,345,675 cash + $3,813,582 accounts receivable
    ᎏᎏᎏᎏᎏᎏ
    $6,126,096 total current liabilities
    = 1.01 acid test ratio
    The general expectation is that a company’s acid test ratio should be 1:1 or better, although you find many more exceptions to this rule than to the 2:1 current ratio standard.
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    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-to-Equity Ratio
    Some debt is good, but too much is dangerous. The debt-to-equity ratio is an indicator of whether a company is using debt prudently or is overburdened with debt that could cause problems. The example company’s debt-to-equity ratio is calculated as follows (see Figure 4.2 for data):
    $13,626,096 total liabilities
    ᎏᎏᎏᎏᎏ
    $13,188,483 total stockholders’ equity
    = 1.03 debt-to-equity ratio
    This ratio reveals that the company is using $1.03 of liabilities for each $1.00 of stockholders’ equity. Notice that all liabilities (non-interest-bearing as well as interest-bearing, and both short-term and long-term) are included in this ratio. Most industrial businesses stay below a 1 to 1 debt-to-equity ratio.
    They don’t want to take on too much debt, or they cannot convince lenders to put up more than one-half of their assets. On the other hand, some businesses are much more aggressive and operate with large ratios of debt to equity. Public utilities and financial institutions have much higher debt-to-equity ratios than 1 to 1.
    Times Interest Earned
    To pay interest on its debt a business needs sufficient earnings before interest and income tax (EBIT). To test the ability to pay interest, the times-interest-earned ratio is calculated. For the example, annual earnings before interest and income tax is divided by interest expense as follows (see Figure 4.1 for data): $3,234,365 earnings before interest and income tax ᎏᎏᎏᎏᎏᎏ
    $795,000 interest expense
    = 4.07 times interest earned
    There is no standard guideline for this particular ratio, although obviously the ratio should be higher than 1 to 1. In this example the company’s earnings before interest and income tax is more than four times its annual interest expense, which is comforting from the lender’s point of view.
    Lenders would be very alarmed if a business barely covered its annual interest expense. The company’s management should be equally alarmed, of course.
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    F I N A N C I A L R E P O R T I N G
    ASSET TURNOVER RATIOS
    A business has to keep its assets busy, both to remain solvent and to be efficient in making profit. Inactive assets are an albatross around the neck of the business. Slow-moving assets can cause serious trouble. Investors and lenders use certain turnover ratios as indicators of how well a business is using its assets and to test whether some assets are sluggish and might pose a serious problem.
    Accounts Receivable Turnover Ratio
    Accounts receivable should be collected on time and not allowed to accumulate beyond the normal credit term offered to customers. To get a sense of how well the business is controlling its accounts receivable, the accounts receivable turnover ratio is calculated as follows (see Figures 4.1 and 4.2 for data):
    $39,661,250 annual sales revenue
    ᎏᎏᎏᎏ = 10.4 times
    $3,813,582 accounts receivable
    The accounts receivable turnover ratio is one of the ratios published by business financial information services such as Dun & Bradstreet, Standard & Poor’s, and Moody’s.