Chapter 6
The Accounting Cycle: Statements and Closing Entries
155
Analyzing the Financial Statements
Financial statements can do more than just tell us how much profit was earned or the total of our
assets or liabilities. Financial statement analysis includes calculating ratios between two values
to provide insight into the business and how well it is operating. This topic will be covered in
more detail later, but for now we will look at a few ratios that indicate how liquid the business is.
Liquidity is the ability of the business to convert current assets to cash to pay its debts as they come
due.
This presentation of the classified balance sheet, which separates current from long-term items,
allows for the easy calculation of working capital, the current ratio and the quick ratio. Each of
these looks at how well the company can pay its debts with its liquid, or current assets.
Working capital
is the difference between current assets and current liabilities. This provides a
dollar figure, which if positive, means the business has more current assets than current liabilities
and should be able to pay its current debt. If current liabilities are greater than current assets, the
business may have difficulty paying its debt as it comes due. Using the values in Figure 6.24, the
working capital for MP Consulting is
Current Assets − Current Liabilities = Working Capital
$8,900 −
$4,075
= $4,825
MP Consulting has more than enough current assets to pay for the current liabilities and should
have no trouble paying the debts as they come due.
The
current ratio
measures a company’s ability to pay off short-term debt.The higher the current
ratio, the more current assets the company has to pay off debt that is due within one year. The
formula is shown below
=
Current Assets
Current Ratio
Current Liabilities
From the balance sheet in Figure 6.24, the current ratio is calculated as
Current Ratio = $8,900
$4,075
= 2.18
This indicates that the company has $2.18 in current assets for every $1.00 in current liabilities.
MP Consulting is doing well, since it has enough current assets to cover its upcoming debt
payments.
