How to Use Accounting Information to Investigate a Business' Solvency
Obtain a company's balance sheet and income statement., Locate the different totals and subtotals on the two financial statements., Use profitability ratios to see how efficient and productive a business is, and how easily its cash flows., Use...
Step-by-Step Guide
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Step 1: Obtain a company's balance sheet and income statement.
For large, publicly trade businesses this shouldn't be too hard to find, since by law they are required to post periodic financial statements. -
Step 2: Locate the different totals and subtotals on the two financial statements.
Important things to look for include:
Net Sales Net Income Current Assets Total Assets Current Liabilities Long-Term Liabilities Total Liabilities Common Stock Retained Earnings , The return on assets ratio is like an overall indicator of how efficiently a business uses its resources.
It is figured by dividing net income by total assets.
The higher the ratio, the better the investment.
The earnings per share ratio is used for businesses that publicly trade stock.
It is found by dividing net income by the average number of outstanding shares.
It should be compared to other companies as well as a business's own previous earnings per share.
The price earnings ratio tells what investors expect to make from a share of stock.
It is calculated by dividing the market value per share by the earnings per share.
A ratio above fifteen is considered excellent.
The dividend yield measures the amount of cash you receive as dividends from one share of stock.
It is found by dividing the amount of annual dividends per share by the price per share.
A low dividend yield doesn't necessarily mean a business is doing bad; it might mean that that business is simply reinvesting more of its profits back into itself. , The current ratio measures a company's ability to repay short-term liabilities with only its short-term assets.
It is found by dividing current assets by current liabilities.
Different industries have different expectations here, but generally anything above one is good.
The quick ratio is like the current ratio, only it is a little more stringent because it excludes inventories from current assets.
Therefore, it is calculated by dividing quick assets, which are current assets minus inventories, by current liabilities.
A ratio of 1:1 is pretty common.
The receivables turnover ratio shows how well a business does in providing credit and collecting its receivables.
It is figured by dividing net credit sales by the average amount of the accounts receivable.
The higher the turnover, the better the business is at collecting debts.
The inventory turnover ratio signifies how often a company sells its inventory and replaces it in a time period.
It is found by dividing the average cost of goods sold by the average inventory.
A high turnover means that a business more than likely has very strong sales. , The long-term debt to total assets ratio shows how much of a company's assets are financed by long-term liabilities, which are defined as those lasting longer than a year.
It is figured by dividing long-term liabilities by total assets.
The times interest earned ratio determines a business's capacity to finance its accrued interest.
It is calculated by dividing income (before interest expense and income tax expense) by the interest expense.
A ratio above two is generally considered good. -
Step 3: Use profitability ratios to see how efficient and productive a business is
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Step 4: and how easily its cash flows.
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Step 5: Use liquidity ratios to see how easily a business is able to pay off its short-term debts and respond to cash needs.
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Step 6: Use solvency ratios to see how easily a business is able to pay off its long-term debts and other obligations.
Detailed Guide
For large, publicly trade businesses this shouldn't be too hard to find, since by law they are required to post periodic financial statements.
Important things to look for include:
Net Sales Net Income Current Assets Total Assets Current Liabilities Long-Term Liabilities Total Liabilities Common Stock Retained Earnings , The return on assets ratio is like an overall indicator of how efficiently a business uses its resources.
It is figured by dividing net income by total assets.
The higher the ratio, the better the investment.
The earnings per share ratio is used for businesses that publicly trade stock.
It is found by dividing net income by the average number of outstanding shares.
It should be compared to other companies as well as a business's own previous earnings per share.
The price earnings ratio tells what investors expect to make from a share of stock.
It is calculated by dividing the market value per share by the earnings per share.
A ratio above fifteen is considered excellent.
The dividend yield measures the amount of cash you receive as dividends from one share of stock.
It is found by dividing the amount of annual dividends per share by the price per share.
A low dividend yield doesn't necessarily mean a business is doing bad; it might mean that that business is simply reinvesting more of its profits back into itself. , The current ratio measures a company's ability to repay short-term liabilities with only its short-term assets.
It is found by dividing current assets by current liabilities.
Different industries have different expectations here, but generally anything above one is good.
The quick ratio is like the current ratio, only it is a little more stringent because it excludes inventories from current assets.
Therefore, it is calculated by dividing quick assets, which are current assets minus inventories, by current liabilities.
A ratio of 1:1 is pretty common.
The receivables turnover ratio shows how well a business does in providing credit and collecting its receivables.
It is figured by dividing net credit sales by the average amount of the accounts receivable.
The higher the turnover, the better the business is at collecting debts.
The inventory turnover ratio signifies how often a company sells its inventory and replaces it in a time period.
It is found by dividing the average cost of goods sold by the average inventory.
A high turnover means that a business more than likely has very strong sales. , The long-term debt to total assets ratio shows how much of a company's assets are financed by long-term liabilities, which are defined as those lasting longer than a year.
It is figured by dividing long-term liabilities by total assets.
The times interest earned ratio determines a business's capacity to finance its accrued interest.
It is calculated by dividing income (before interest expense and income tax expense) by the interest expense.
A ratio above two is generally considered good.
About the Author
Brenda Sullivan
Specializes in breaking down complex DIY projects topics into simple steps.
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