Net working capital =
Current assets - Current liabilities |
Does the business have enough financial strength
to continue operations for a reasonable period?
A simple measure of short-term stability is whether
current assets (cash, cash equivalents, and assets
that should be reduced to cash within a year) exceed
current liabilities (those that come due within
a year). |
Current ratio =
Current assets / Current liabilities |
How adequate is working capital? The current
ratio -- current assets divided by current
liabilities -- reveals the company's ability to
pay current debts. Financial analysts use a rule
of thumb that an industrial company should have
a current ratio of 2 to 1. But if the company has
small inventory levels and the readily-collectible
accounts receivable, a lower current ratio that
is acceptable. |
| Acid test
- Quick assets = Cash + marketable securities
+ current receivables
- Net quick assets = Quick assets - current
liabilities
- Quick assets ratio = Quick assets / current
liabilities
|
How would the company do in
a financial pinch? Bankers and other short-term
lenders to a business often look at quick assets
which could be used in an emergency. Quick assets,
unlike current assets, exclude inventories. The
quick assets ratio is usually referred
to as the acid test -- where a ratio of 1.0 or better
shows the company could meet its current liabilities
without liquidating inventory. A ratio less than
1.0 may not be a danger sign if anticipated cash
flow (from sales) will meet the debt burden. |
Book value of shares =
(Assets - Liabilities) / # Shares |
What is the company's value, based on the balance
sheet? Book value of shares is simply the
value of a company's shares calculated from the
balance sheet (the books) of the company. In our
balance sheet above, book value would be $200 ($200,000
shareholders' equity / 1,000 shares outstanding).
Book value rarely represents what somebody would
pay for a corporation or event what its liquidation
value might be, since it is based on historical
cost and not earnings potential. |
Asset coverage of debt =
(Total assets - Current liabilities) / Long-term
debt |
How secure is a long-term debt holder? Asset
coverage of debt is a ratio of total assets
minus current liabilities (that is, money available
for long-term debtholders) divided by the amount
of long-term debt, all computed at book value. This
calculation does not take account of equity holders
since the long-term debtholders are senior -- that
is, they are entitled to full payment before shareholders
get anything. |
Debt/equity ratio =
Long-term debt / Total equity |
How much of permanent capital is borrowed?
The debt/equity ratio recognizes that long-term
debt is a kind of permanent capitalization of
the business. The debt/equity ratio shows the
proportion of permanent capital that is borrowed
to that contributed by shareholder or generated
internally as retained earnings. This is important
since borrowed capital must be paid interest,
while dividends are usually discretionary. Large
amounts of debt make the business more risky.
A company with a high debt/equity ratio is said
to be highly leveraged.
The debt/equity ratio gives lenders an idea of
the equity "cushion" available to repay
them in case of default. A high debt/equity ratio
means a relatively small cushion and a greater
risk the lender will not fully collect in the
event of a default.
|
3.2.2 Balance Sheet Analysis