Terminology Used in Ratio Analysis

Let me clarify some of the terminology used in my previous posting regarding Common Accounting Ratios.

Assets – Things owned by the entity (i.e. fixed assets, cash, CD’s, etc.)

Current Assets (CA) – Assets owned by the entity which are available within the next period’s accounting cycle (typically one year). For example, current assets would include prepaid insurance policies, cash, CD’s maturing within 1 year, inventories, accounts receivable (unless the receivable is not expected to be collectible within the accounting cycle). Fixed assets, are not current assets because they are not available to pay the debts of the organization within the accounting cycle (the assets are used in operations and are not necessarily available for liquidation to pay liabilities).  On a classified balance sheet, current assets are usually subtotaled to aid in the readability and overall usefulness of the financial statements.

Liabilities – Essentially, liabilities are the debts owed by the Company. Some liabilities are hard/concrete liabilities such debt payments or accounts payable for purchases received. Other items are estimates such as payroll and taxes for services performed but not yet paid.

Current Liabilities (CL) – Liabilities expected to be due within the next year. Please note that this is not the liabilities expected to be paid within the next year. A liability may be due but not paid within the next year; it should still be included as a current liability because the obligation is due in the current period.

Cost of Goods Sold or Cost of Sales (COGS or COS) – The cost of inventory sales or the costs directly associated with the products being sold. This item is important to understanding the overall gross margin of sales.

Gross Margin (GM) – Gross margin is the ratio of profit earned per sale. This is different from the profit margin ratio because this excludes items not directly related to the sales (i.e. excludes selling and administrative costs which are not directly related to the sales). For example cost of goods sold would include the inventory expense (cost of purchasing or producing) the products sold but would not include the salesman’s salary due to the salesman being necessary to the overall operation of the Company and not that specific sale.

Profit Margin (PM) – This ratio is a measure of a company’s  overall profitability per each item sold and includes selling and administrative costs in addition to the costs of goods sold.

Quick Tip - Common Accounting Ratios

Ratio's can be useful tools when analyzing data. Ratios allow you to test the reasonableness of information underlying the data and they allow you to assess some general assumptions about the profitability or financial strength of an organization.

Liquidity Ratios - Liquidity ratios measure the ability to pay short term obligations. Common liquidity ratios are:

• Current Ratio -- current assets / current liabilities
• Quick (Acid Test) Ratio -- liquid assets / current liabilities
• Current Cash debt Ratio -- Net cash provided by operating / Average current liabilities

Activity Ratios - Activity Ratios measure the turnover, or turn-around time, of an asset and help to understand the overall cash flow cycle. For example faster accounts receivable turnover, the more cash available. Alternatively, the faster the accounts payable turnover, the less cash there is available at any given time. Some common activity ratios are:

• Accounts Receivable Turnover -- Net sales / Average trade receivables (net of allowance)
• Inventory turnover -- Cost of Goods Sold (COGS) / Average inventory
• Asset Turnover -- Net sales / Average total assets

Profitability Ratios - Profitability Ratios measure the degree of success or failure of a given enterprise or division for a particular period of time. Some common profitability ratios are:

• Profit Margin (PM) -- Net income / Net sales
• Return On Assets (ROA) -- Net income / Average total assets
• Return On Common Stock Equity (ROE) -- Net income (less preferred dividends) / Average common shareholder's equity
• Earnings Per Share (EPS) -- net income (less preferred dividends) / Weighted average shares outstanding
• Price Per Earnings (PPE) -- Market price of stock / Earnings per share
• Payout Ratio -- Cash dividends / Net income

Coverage Ratios - Coverage Ratios measure the extent of debt in relation to assets. This ratio is important to investors and creditors because they measure the amount of leveraging. While, a highly leveraged company can be highly profitable, they have a relatively small amount of assets in the event of liquidation. Some common coverage ratios are:

• Debt to Total Assets -- debt / Total assets
• Times Interest Earned (TIE) -- Income before interest and taxes / Interest expense
• Cash Debt Coverage Ratio -- Net cash provided by operating / Average total liabilities
• Book Value Per Share -- Common stockholder's equity / Outstanding shares of common
  

Quick Tip - Transposition error

Have a transposition error? How do you know?

A transposition error occurs when you leave a zero off a number or reverse a number. The rule of thumb is that if something doesn't balance and the difference is divisible by 9 then it's a transposition error.

So, here's the trick. Anyone can divide the difference by 9 in excel or whatever your using, but here's a trick the old timer's use: add the numbers up, if you get a 9, the number is divisible by 9.

For example:

• Difference of 27; 2 + 7 = 9 - transposition error

• Difference of 2749; 2 + 7 + 4 +9 = 22; 2 + 2 = 4 - not a transposition error

• Difference of 5733; 5+ 7+ 3 + 3 = 18; 1+ 8+ = 9 - transposition error

Works great for narrowing down errors when entering trial balances but if you are just footing something and it's not too long, just foot it twice in excel and then use a third column to subtract one footing from the other and you can find your errors.

Accounting Codification

I know it will be nice once I get used to it, but for now I am dreading having to update all of my references to the new codification. I am sure that I am not the only person out there. But honestly, I don't think it will be that bad. The new codification seems pretty straightforward; what's not better than the current system of the litany of standards. I think the hardest thing for me is going to be remembering to reference the new codification in the workpapers, when drafting and tying out financial statements I will be looking for those things but I am certain to overlook a few in the workpapers until I get used to using the new references.

Here are some sites I found that have some good articles and/or tools relating to the new codification:

• A really useful chart from PwC
• A general overview from the AICPA 
• Really good quick reference chart to the FASB ASC in comparison to some commonly referenced FASB standards standards; the chart is available via google search and doesn't give a name, but a quick search of gbq reveals a likely candidate
• Good overview by KPMG; includes a brief summary of what to do if an error in prior periods is discovered as a result of implementing the standards 
• A nice snapshot from Grant Thornton