Accounting: The Language of Business - Vol. 1 (Part 102)

Creative accounting is an absolute curse to a civilization. One could argue that double-entry bookkeeping was one of history’s great advances. Using accounting for fraud and folly is a disgrace. In a democracy, it often takes a scandal to trigger reform. Enron was the most obvious example of a business culture gone wrong in a long, long time.

– Charlie Munger

 Financial Statement Analysis (Part B)

by

Charles Lamson

Solvency Analysis

Some aspects of a business's financial condition and operations are of greater importance to some users of financial statements than others. However, all users are interested in the ability of a business to pay its debts as they are due and to earn income. The ability of a business to meet its financial obligations (debts) is called solvency. The ability of a business to earn income is called profitability.

The factors of solvency and profitability are interrelated. A business that cannot pay its debts on a timely basis may experience difficulty in obtaining credit. A lack of available credit may, in turn, lead to a decline in the businesses profitability. Eventually, the business may be forced into bankruptcy. Likewise, a business that is less profitable than its competitors is likely to be at a disadvantage in obtaining credit or new capital from stockholders.

In the next few posts we discuss various types of financial analyses that are useful in evaluating the solvency of the business. In the next section, we discuss various types of profitability analysis. The examples in both sections are based on Lincoln Company's financial statements presented in part 101. In some cases, data from Lincoln company's financial statements of the preceding year and from other sources are also used. These historical data are useful in assessing the past performance of the business and in forecasting its future performance. The results of financial analyses may be even more useful when they are compared with those of competing businesses and with industry averages.

Solvency analysis focuses on the ability of a business to pay or otherwise satisfy its current and noncurrent liabilities. It is normally assessed by examining balance sheet relationships, using the following major analyses:

1. Current position analysis

2. Accounts receivable analysis

3. Inventory analysis

4. The ratio of fixed assets to long-term liabilities

5. The ratio of liabilities to stockholders equity

6. The number of times interest charges are earned 

Current Position Analysis

To be useful in assessing solvency a ratio or other financial measure must relate to a business's ability to pay or otherwise satisfy its liabilities. Using measures to assess a business's ability to pay its current liabilities is called current position analysis. Such analysis is of special interest to short-term creditors.

An analysis of a firm's current position normally includes determining the working capital, the current ratio, and the quick ratio. The current and quick ratios are most useful when analyzed together and compared to previous periods and other firms in the industry.

Working Capital

The excess of the current assets of a business over its current liabilities is called working capital. The working capital is often used in evaluating a company's ability to meet currently maturing debts. It is especially useful in making monthly or other period-to-period comparisons for a company. However, amounts of working capital are difficult to assess when comparing companies of different sizes or in comparing such amounts with industry figures. For example, working capital of $250,000 may be adequate for a small local hardware store, but it would be inadequate for all of Lowe's.

Current Ratio

Another means of expressing the relationship between current assets and current liabilities is the current ratio. This ratio is sometimes called the working capital ratio or banker's ratio. The ratio is computed by dividing the total current assets by the total current liabilities. For Lincoln Company, working capital and the current ratio for 2023 and 2022 are as follows.

The current ratio is a more reliable indicator of solvency than is working capital. To illustrate, assume that as of December 31, 2023, the working capital of a competitor is much greater than $340,000, but its current ratio is only 1.3. Considering these facts alone, Lincoln Company, with its current ratio of 2.6, is in a more favorable position to obtain short-term credit than the competitor, which has the greater amount of working capital.

Quick Ratio

The working capital and the current ratio do not consider the makeup of the current assets. To illustrate the importance of this consideration, the current position data for Lincoln Company and Jefferson Corporation as of December 31, 2023, are as follows:

Both companies have a working capital of $340,000 and a current ratio of 2.6. But the ability of each company to pay its current debts is significantly different. Jefferson Corporation has more of its current assets in inventories. Some of these inventories must be sold and the receivables collected before the current liabilities can be paid in full. Thus, a large amount of time may be necessary to convert these inventories into cash. Declines in market prices and a reduction in demand could also impair its ability to pay current liabilities. In contrast, Lincoln company has cash and current assets (marketable securities and accounts receivable) that can generally be converted to cash rather quickly to meet its current liabilities.

A ratio that measures the "instant" debt paying ability of a company is called the quick ratio or acid-test ratio. It is the ratio of the total quick assets to the total current liabilities. Quick assets are cash and other current assets that can be quickly converted to cash. Quick assets normally indicate cash, marketable securities, and receivables. The quick ratio data for Lincoln Company are as follows: 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 697-699*

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