Accounting methods and analysis may provide many clues to the quality of a company. Having liquidity and being able to meet short and long term obligations is essential for any business. Lenders or investors should know that having enough working capital is essential for the success of any business. Formulas may be used to determine a quick analysis.
For a company to meet short term obligations one might want to use the Quick Ratio:
Current Assets – inventories / Liabilities = Quick Ratio
The Current ratio helps analyze the ability of a company to cover short term obligations. A current ratio of 2.0 or higher is generally considered attractive.
Current Assets / Current Liabilities = Current ratio
The Debt to Equity Ratio reveals the dependence on debt for the operation of the company. Generally, the lower the number the less dependence the business has on debt for their operations.
Total Liabilities + Shareholder Equity = Debt to Equity Ratio
The cash conversion cycle (CCC) is useful to measure to view the company inventory and how it applies to production and sales and applies it to operations and terms from creditors. A shorter work cycle indicates a better position of working capital.
Days Sayles outstanding + Days Payable Outstanding + Days Inventory Outstanding
= The Cash Conversion Cycle.
A full understanding of the industry along with the individual business will make this analysis more useful. Using a combination of ratios may help a more complete understanding of the balance sheet and helps lenders and investors understand their risk.
A resident of Willowbrook, Illinois, Eric Baumbach is currently studying for a dual bachelor’s degree in accountancy and finance at the University of Illinois at Urbana-Champaign. He is a member of the university chapter of the Alpha Phi Omega service fraternity, served as past director of finance and as a member of several committees. He also serves as a volunteer consultant for entreCORPS, an organization dedicated to developing and offering the best solutions to startups, municipalities and businesses.