Can You Get Net Assets From Statement Of Cash Flows Four Critical Financial Ratios

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Four Critical Financial Ratios

Most startups fail due to financial problems. Potential investors are well aware of this.

Just as the captain of a ship watches for signs of danger on deck, an entrepreneur should use several financial ratios to determine if the company is about to run aground. These ratios exist to measure and judge the status quo, so in this paper we review some key ratios.

By using these instruments, suboptimal outcomes can be predicted and possibly avoided.

Review of assets and liabilities

Balance sheets categorize a company’s assets as either current assets or long-term assets. Current assets are expected to benefit the company in the next year. Long-term funds provide benefits for more than one year.

An example of a short-term asset could be a certificate of deposit with a maturity of six months. A long-term asset can be a machine that is expected to operate for many years.

In addition to cash, a company usually has more assets on its balance sheet. A company can invest its money in financial instruments such as money market accounts, certificates of deposit or US Treasury bills. Because these investments can be quickly converted into cash, general accounting practice treats them as cash equivalents. Cash and cash equivalents are considered current assets.

Similarly, a company has short-term liabilities and long-term liabilities. Short-term liabilities are those that fall due in the next year. Long-term liabilities are those that will be paid off over several years.

Return on assets

One common measure of a business is return on assets (ROA). Return on assets helps a potential investor gain insight into how profitably a company is using its assets.

If Company A shows a 9% ROA while Company B shows a 23% ROA, we see that Company B is getting a much higher return on its assets. A higher ROA could represent a competitive advantage that makes Company B an attractive investment. Conversely, if you own Company A, it’s a good idea to check how your competition is making more profit per dollar of assets.

The ROA formula is:

ROA = Net Profit / Average Total Assets

Net income can easily be found on a company’s income statement. The average balance sheet total is calculated by adding the value of the balance sheet total at the beginning of the year to the value of the balance sheet total at the end of the year. Divide this sum by two.

Debt ratio

The more debt a company takes on, the more likely it is that the company will be unable to pay that debt. The debt ratio shows the percentage of assets that are financed by liabilities. The debt ratio formula is:

Debt ratio = total liabilities / total assets

In the spring of 2017, Exxon Mobile had a debt ratio of 49% (162,989.00/330,314.00). The remaining 51% is financed by the company’s shareholders. By comparison, BP has a debt ratio of 64%. If there is an economic crisis and less sales, which of these companies is more likely to default on their debts?

Current relationship

More immediate are current liabilities that the company has: liabilities that must be paid in the next year. The current ratio gives investors insight into a company’s ability to pay its short-term obligations. For this we use the following formula:

Current ratio = Total current assets / Total current liabilities

The higher the ratio, the stronger the financial position. Using Lumber Liquidators as the exit flooring company, we get a current ratio of 8.86. This ratio reveals that for every $1.00 of current debt Lumber Liquidators has to pay off over the next year, it has $8.86 available!

On the other hand, American Airlines has a current ratio of 0.76 at the time of this writing, meaning that the company has just seventy-six cents for every dollar of debt it has to pay off over the next year. One company is clearly struggling to pay its bills more than the other.

Acid Test Ratio (i.e. Quick Ratio)

The acid test ratio is a more sophisticated version of the current ratio. All of the current assets used in the current ratio are not always readily convertible to cash (if the company needs to pay off debt quickly). It is important that stocks are excluded when using the acid test. The formula is:

Acid-Test = Cash and Equivalents + Market. Securities + accounts. Receivables / Total short-term liabilities

When we re-examine Lumber Liquidators with the acid-test ratio, we get a value of 0.22 – a much worse result than the current ratio. There are several interesting implications here. Lumber Liquidators is a company whose current value comes primarily from its inventory. He has relatively little cash on hand. A shrewd investor can take this information and try to imagine situations in which a stock-heavy company might suffer, and then estimate how likely those episodes might be to occur.

American Airlines, whose current assets depend less on inventory and more on cash and receivables, has an acid test ratio of 0.90.

Conclusion

Cash is the lifeblood of a business. Even when sales are good, business owners often look for additional sources of cash to grow the business—either through debt or equity. The information presented in the balance sheet, income statement, and cash flow statement are critical for outside investors to decide whether to provide that money to the company. The ratios presented here provide operational insight not only for potential investors but also for current business owners.

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