Monitoring Your Company's Financial Position
Determining a company's liquidity
A critical need for small (and all) businesses is having sufficient money on hand to meet their payroll and to pay the other obligations when they come due. This is associated with the term liquidity, which is often assessed by comparing a company's current assets to its current liabilities. In our topic Working Capital and Liquidity we discuss this and the following financial ratios in detail:
Working capital which is the amount of current assets minus the amount of current liabilities.
Current ratio which is the amount of current assets divided by the amount of current liabilities.
Quick ratio which is similar to the current ratio except that inventory and prepaid expenses are excluded from the amount of current assets. The quick ratio is also known as the acid-test ratio.
Receivables turnover ratio which is the amount of sales on credit for a year divided by the average balance in accounts receivable during the year. A related financial ratio is the days' sales in receivables (average collection period).
Inventory turnover ratio which is the cost of goods sold for a year divided by the average cost of inventory during the year. A related financial ratio is the days' sales in inventory (days to sell).
The two "turnover" ratios in the above list highlight that it is not sufficient to merely have accounts receivable and inventory. These current assets must also be converted to cash in time to pay the company's obligations when they come due.
Of course, the company must have practices and procedures to assure that credit is granted only to credit worthy customers, that accounts receivables are monitored and collected when due, that inventory levels are managed, and that internal controls are in place to safeguard all assets.
Determining a company's ability to obtain long-term loans
The balance sheet also provides information on a corporation's ability to obtain long-term loans. For instance, if a corporation has a large amount of debt (the combination of current and long-term liabilities) compared to the amount of its stockholders' equity, the corporation is said to be highly leveraged. A high level of financial leverage may be viewed by lenders as a high level of risk.
Here are two financial ratios which are often used for determining the level of a corporation's financial leverage:
Debt to equity ratio which compares a corporation's total debt (current liabilities + long-term liabilities) to the amount of stockholders' equity.
Debt to total assets ratio which compares a corporation's total debt to the total amount of its assets.
If a corporation is highly leveraged, a lender may not be interested in making new or additional loans to the corporation.
Of course, lenders will also exam other financial information including:
- The corporation's notes to its financial statements
- The corporation's income statements
- The corporation's statements of cash flows
Issuing additional common stock or additional bonds
Some corporations may be able to issue additional shares of its common stock and/or to issue bonds to obtain money for purchasing long-term assets, expanding operations, reducing the amount of its short-term debt, etc.
Issuing shares of common stock has advantages and disadvantages:
It has the advantage of increasing the amount of stockholders' equity thereby reducing the corporation's degree of financial leverage. The reduction in financial leverage could also allow the corporation to obtain additional loans.
It has the disadvantage of diluting an existing stockholder's percent of ownership in the corporation.
Issuing bonds also has advantages and disadvantages:
One advantage of bonds is their low cost since the interest paid to the bondholders will be a deductible expense on the income tax return of a profitable corporation. Another advantage is that an existing stockholder's percent of ownership is not reduced.
A disadvantage of bonds is the increase in the corporation's liabilities, thereby increasing the corporation's financial leverage. This will be interpreted to mean additional risk.
Some Limitations of the Balance Sheet
Some assets are not included
Due to the accounting principle known as the cost principle (or historical cost principle), some valuable trademarks developed internally by a company are not reported as assets on its balance sheet. For example, the internationally recognized trademarks developed by Coca-Cola and Nike might be among their most valuable assets. However, these trademarks are not reported on their balance sheets since they were not purchased in a transaction with another party.
NOTE: If a company purchases a brand name and trademark from another business at a cost of $1 million, this cost will be recorded by the company at the time of the transaction. So long as there is no impairment to the brand, the $1 million cost will be reported on the company's future balance sheets.
However, if the same company creates and develops a successful, valuable brand and trademark through its astute marketing, those marketing costs are expensed when they occur. As a result, this valuable brand name and trademark will not be reported as assets on the company's balance sheets.
Similarly, the cost principle prevents a company's balance sheet from including the value of its highly effective management, its research team, customer allegiance, unique marketing strategies, etc.
Balance Sheet Should Be Read With the Other Financial Statements
A corporation's balance sheet and the notes to the financial statements should be read along with the corporation's other financial statements:
- Income statement
- Statement of comprehensive income
- Statement of cash flows
- Statement of stockholders' equity
The FASB's Highlights of FASB's Statement of Financial Accounting Concepts No. 5 (issued in 1984) states, "no one financial statement is likely to provide all the financial statement information that is useful for a particular kind of decision."
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