Business Ratios and Formulas phần 4 ppsx

WORKING CAPITAL PRODUCTIVITY Description: The working capital productivity measure is similar to the sales tocurrent assets ratio, in that both are used to see if there are enough assets

The table shows that the sales to current assets ratio is increasing over time,with an especially dramatic jump in the last year that is caused by a rapid decline

in the amount of current assets This means that the company may fail suddenly.The auditor decides to conduct some tests to verify whether a major liquidityproblem exists

Cautions: This ratio is not valid in situations where a company is selling goods

on a drop-ship arrangement with its supplier, since this means that the companyrecords sales even though it never has possession of the goods, which are shippeddirectly from the supplier to the customer Under this arrangement, a company cantheoretically have no inventory at all

The ratio’s results can also be suspect in cases where a company accepts a largepart of its sales with credit card payments, since this will drop accounts receivablebalances to near zero, depending upon whether cash receipts are recognized at thetime when a credit card sale is recorded or when cash is received from the banksupporting the customer’s credit card In both the drop-shipping and credit cardsituations, current assets are legitimately reduced by the type of logistical andsales operations conducted by a company and so should not be construed as being

an indicator of poor liquidity

WORKING CAPITAL PRODUCTIVITY

Description: The working capital productivity measure is similar to the sales tocurrent assets ratio, in that both are used to see if there are enough assets available

to support a given level of sales activity The working capital productivity measuretends to be somewhat more accurate, since it subtracts current liabilities from cur-rent assets to arrive at a net current asset figure that may be considerably less thanthe total current assets figure used in the other measurement

Alternatively, an excessively low working capital productivity measurementreveals that a company is inefficient at producing sales because it has too much in-vested in accounts receivable and/or inventory to produce a given level of sales.The measure can be compared to the results of competitors to see if the company

is using its working capital in the most effective manner

Formula: Divide annual sales by total working capital It may also be useful tocalculate average working capital, in case the ending working capital for the re-porting period is unusually high or low The formula is:

that the company is very slow in paying its bills, which indicates that its liquidity

is not as good as indicated by the sales to current assets ratio Accordingly, thelender obtains the company’s most recent balance sheet, which contains the fol-lowing information:

An inordinate amount of accounts payable reduces the amount of working ital available to support sales, resulting in far fewer net assets than was initially in-dicated by the sales to current assets ratio The lender should be concerned aboutthe ability of the company to continue as a going concern

cap-Cautions: This is generally a reliable measure, but its main failing is in the rivation of the annual sales figure in the numerator If the sales figure used here de-parts considerably from the annualized amount of sales within the recent past, thenthe ratio will not result in a good comparison of sales level to working capital re-quirements There can also be a problem if the measurement is made at the end of

de-a high sede-asonde-al sde-ales pede-ak, since de-annude-alized sde-ales will de-appede-ar to be quite high, butthe inventory component associated with working capital will have been greatlyreduced, resulting in a ratio that appears to be too high

DAYS OF WORKING CAPITAL

Description: A company can use a very large amount of working capital to erate a small volume of sales, which represents a poor use of assets The inefficientasset use can lie in any part of working capital—excessive quantities of accounts

gen-receivable or inventory in relation to sales, or very small amounts of accountspayable The days of working capital measure, when tracked on a trend line, is agood indicator of changes in the efficient use of working capital A low number ofdays of working capital indicates a highly efficient use of working capital.

Formula: Add together the current balance of accounts receivable and inventory,and subtract accounts payable Then divide the result by sales per day (annualsales divided by 365) The formula is:

(Accounts receivable + Inventory – Accounts payable)

——————————————————–————

Net sales / 365

Example: The Electro-Therm Company, maker of electronic thermometers, hasaltered its customer service policy to guarantee a 99% fulfillment rate within oneday of a customer’s order To do that, it has increased inventory levels for manystock keeping units Electro-Therm’s CFO is concerned about the company’s use

of capital to sustain this new policy; she has collected the information in Table 5.9

to prove her point to the company president

The table reveals that Electro-Therm’s management has acquired an additional

$1,095,000 of revenue (assuming that incremental sales are solely driven by thecustomer service policy change) at the cost of a nearly equivalent amount of in-vestment in inventory Depending on the firm’s cost of capital, inventory obsoles-cence rate, and changes in customer retention rates, the new customer service policymay or may not be considered a reasonable decision

Cautions: Working capital levels will vary through the year, depending on a pany’s business cycle, which will alter the days of working capital figure depend-ing on the month of the year For example, if a firm has a Christmas selling season,then it will build inventory until its prime selling season, resulting in a gradual in-crease in the days of working capital measure for most of the year

com-Table 5.9

Days of

Period Receivable Inventory Payable Capital Net Sales Day Capital

DEFENSIVE INTERVAL RATIO

Description: The defensive interval ratio shows the number of days that acompany can operate with its existing liquid assets, based on an expected amount

of upcoming operating expenses There is no set minimum number of days that isconsidered acceptable; instead, this measure should be tracked on a trend line tosee if a company’s ability to pay its bills is gradually being reduced over time

Formula: Add together all cash, marketable securities, and accounts receivable.Then determine the amount of expected daily operating expenses by compilingknown upcoming expenses and creating a daily average expense Finally, dividethe average daily expense into the liquid assets When deriving the amount of liq-uid assets, do not include any marketable securities that cannot be liquidated in theshort term nor any of the accounts receivable for which collection is in doubt Theformula is:

Cash + Marketable securities + Accounts receivable

Expected daily operating expenses

Example: The Intrusive Burglar Alarm Company, maker of really loud alarmsirens, is short on cash It is expecting a large payment in 40 days that will relieveits cash difficulties In the meantime, the CFO needs to determine if there isenough liquidity to cover short-term expense requirements The company requiresroughly $13,000 on a daily basis to cover its expenses and that it has cash of

$42,000, marketable securities of $119,000, and accounts receivable of $255,000.Using this information, the CFO calculates the defensive interval ratio as:

Cash + Marketable securities + Accounts receivable

—————————————————————— =

Expected daily operating expenses

$42,000 Cash + $119,000 Marketable securities + $255,000 Accounts receivable =

——————————————————————————————— =

$13,000 Expected daily operating expenses

32 DaysBased on this calculation, it appears that the company will run out of cash after

32 days, leaving eight days before the large cash inflow will occur The CFO gins calling lenders to obtain a short-term loan to cover the projected shortfall

be-Cautions: The amount of expected daily operating expenses used in the nator is an average figure; however, the actual amount of expenses paid on a dailybasis is more uneven For example, a large rent or payroll payment may be due on

denomi-a specific ddenomi-ate, denomi-although it is incorpordenomi-ated into the expected ddenomi-aily operdenomi-ating pense figure as a much smaller daily payment that is spread over the entire rent pe-riod The presence of one or more of these large lump-sum payments can rapidly

ex-drain a company’s cash reserves, resulting in a much lower amount of liquid sets than the measurement would otherwise indicate To avoid this problem, oneshould supplement the measure with a detailed review of the exact timing of pay-ments for upcoming accounts payable.

as-Another problem with this measurement is that it assumes a static amount ofaccounts receivable However, any business with ongoing sales will have a con-stant inflow of new accounts receivable, as customers are provided with goods andservices Consequently, the defensive interval ratio can be much longer than theinitial calculation may indicate, as long as new accounts receivable are being gen-erated that will be converted into cash during the time period when existing liq-uidity is projected to cover daily expenses

CURRENT LIABILITY RATIO

Description: The current liability ratio is used to determine the proportion oftotal liabilities that are due for payment in the near term This is only an approxi-mate measure of liquidity, since it does not indicate the ability of a company topay its liabilities, whether the liabilities are extensive or small Consequently, it ismost useful when tracked on a trend line, to see if a company’s proportion of cur-rent liabilities to total liabilities is worsening or improving over time

Formula: Divide current liabilities by total liabilities An alternative approach is

to list in the numerator only those liabilities that are due for payment within ashorter time frame, such as the next month or quarter This approach gives a bet-ter idea of the proportion of very short-term liabilities to all liabilities The basicformula is:

Current liabilitiesTotal liabilities

Example: The Powder Hound Snowmobile Company’s new CFO thinks that itmay be time to restructure the company’s debt so that more of it can be shifted outinto the future The CFO begins by reviewing the current liability ratio for the pastthree years to see if the proportion of short-term liabilities to total liabilities has in-creased, and accumulates the information shown in Table 5.10

The data reveal that the company has come to rely upon short-term debt sequently, the CFO elects to conduct negotiations with lenders, with the objective

Con-of converting many Con-of these short-term liabilities into long-term ones

Cautions: As noted in the description, this ratio yields an approximate view of acompany’s liquidity, since it does not show the ability of the company to pay anyamount of liabilities Also, the dividing line for determining the presentation of aliability as current or not is its requirement to be paid within one year; if a liabil-ity’s due date is slightly longer than one year, it will only appear in the denomi-nator Therefore, the one-year cutoff is an arbitrary factor that can skew the results

of the measurement

Another issue is that a company may have a very high current liability ratio, ply because it has paid off its long-term debt or is in its final year of debt payments(which are categorized as short-term debt) Similarly, there may be no need for anylong-term debt In both cases, the ratio appears to reveal an unwise dependence onshort-term debt, when in reality the company is in good financial condition

sim-REQUIRED CURRENT LIABILITIES TO TOTAL CURRENT

LIABILITIES RATIO

Description: A comparison of required current liabilities to total current liabilities

is a good measure for determining a company’s extremely short-term liabilityproblems If the numerator increases over time as a proportion of the total ratio,then this indicates that creditors are maintaining a close watch over payment duedates, which shows that the company is having difficulty obtaining credit that doesnot have extremely tight payment requirements

Formula: Divide the total amount of all current liabilities with required paymentdates by the total of all current liabilities The amount of liabilities recorded in thenumerator is subject to some degree of interpretation; for example, it may includeonly those liabilities coming due within the next week, or month, or quarter Someexperimentation with the ratio’s results is needed to determine the exact time pe-riod used and the relevance of the resulting information The formula is:

Current liabilities with required payment dates

———————————————————

Total current liabilities

Example: A small fertilizer company is rapidly running out of cash It needs to getthrough the next month to enter its prime spring selling season and bring in somecash Accordingly, the controller decides to measure the proportion of current lia-bilities with a one-month due date or less to total current liabilities in order to gain

a better understanding of how many dollars of payments are coming due Within theone-month time frame, the company must pay $148,000, while its total current lia-bilities are $197,000 Using this information, the controller calculates the ratio as:

Current liabilities with required payment dates

——————————————————— =

Total current liabilities

$148,000 Current liabilities with required payment dates

———————————————————————— =

$197,000 Total current liabilities75% Required current liabilities to total current liabilities ratio

Cautions: This ratio does not reveal a great deal of information if measured only for

a single period, since there is no way to compare it to historical information A ter approach is to measure it on a trend line, or to compare it to the same period inthe preceding year, when the liability proportion should have been about the same.Also, the ratio does not reveal how much cash is actually needed for short-termpayment requirements, so it should be supplemented with a short-term cash forecastthat itemizes the precise cash flows to be expected over the measurement period

bet-WORKING CAPITAL TO DEBT RATIO

Description: The working capital to debt ratio is used to see if a company couldpay off its debt by liquidating its working capital This measure is used only incases where debt must be paid off at once, since the elimination of all workingcapital makes it impossible to run a business and will likely lead to its dissolution

Formula: Add up cash, accounts receivable, and inventory, and subtract all counts payable from the sum Then divide total debt into the result A variation is

ac-to use only short-term debt in the denominaac-tor, on the grounds that only this tion of the debt will come due for payment The formula is:

por-Cash + Accounts receivable + Inventory – Accounts payable

—————————————————————————

Debt

Example: The financial performance of the Open Sesame Door Company, ers of voice-activated door systems, has been so poor that it has violated all of itsbank covenants Because of the covenant violations, the bank has elected to call inits loan immediately The bank vice president wants to see if the company can payoff the loan from its current resources and so examines the company’s latest bal-ance sheet and sees this information:

mak-Balance Sheet Line Item Amount

The vice president uses this information to calculate the working capital to debtratio:

Cash +Accounts receivable + Inventory – Accounts payable

of its money back However, a closer examination of the components of workingcapital reveals that current cash and receivable levels would only pay off accountspayable, leaving the loan to be paid from the much less liquid inventory balance

Consequently, the company may have a very difficult time paying back any of the

loan The bank vice president elects to work with company management toachieve a payback over a longer time period

Cautions: As noted in the example, one component of the working capital figure that

is used in the numerator is inventory, which is not nearly as liquid as cash or accountsreceivable If the proportion of inventory to working capital is high, then a company’sapparent ability to pay off a debt in the short term will be exaggerated by this ratio

RISKY ASSET CONVERSION RATIO

Description: The risky asset conversion ratio is a useful way to determine theproportion of a company’s recorded assets that are unlikely to be easily convert-ible into cash This is of considerable interest to an acquirer or lender, since theseentities need to understand the underlying value of the corporation in which theyare investing debt or equity The ideal ratio result should be as small as possible

If a company has a high ratio, then it not only has little liquidation value, but alsomay be in danger of going out of business if it must suddenly pay off a largeamount of liabilities with its small proportion of concrete assets

Formula: Summarize the cost of all assets with a minimal conversion value, net

of depreciation and amortization, and divide by total assets The numerator shouldinclude all intangibles as well as all highly customized equipment (since thesemay be especially difficult to sell) The formula is:

Cost of assets with minimal cash conversion value

Total assets

Example: A potential acquirer is reviewing the financial information of the terson Motor Company (PMC), with the intention of selling off its assets The ac-quirer has conducted a brief review of all PMC assets and elects to calculate therisky asset conversion ratio with the information shown in Table 5.11.

Pe-The acquirer inserts this information into the risky asset conversion formula,which is:

Cost of assets with minimal cash conversion value

Cautions: The components of this measurement are subject to a great deal of terpretation, since few people have a clear understanding of the market value ofassets, especially those that are customized and therefore have a limited resalemarket For an accurate measurement, an appraiser should regularly review a com-pany’s entire list of assets

in-NONCURRENT ASSETS TO in-NONCURRENT LIABILITIES RATIO

Description: This ratio is used by lenders to determine the amount of long-termassets on hand that can be used to pay off long-term debt A ratio equal to orgreater than one is indicative of having a reasonable ability to do so However,there are several problems with this ratio, as enumerated later in the Cautionssection

Table 5.11

Amortization of intangible assets $60,000

Depreciation on customized equipment $120,000

Formula: Divide the net book value of all noncurrent assets by all noncurrent abilities To be more conservative, eliminate from the numerator all intangible as-sets, since the liquidation value of these assets may be minimal The formula is:

The lending officer elects to exclude the goodwill asset from the noncurrent sets to noncurrent liabilities ratio, since this item may not have any resale value.The measurement is calculated as:

as-Noncurrent assets

————————— =Noncurrent liabilities

$815,000 Fixed assets – $350,000 Depreciation

———————————————————— =

$1,500,000 Long-term debt31% Noncurrent assets to noncurrent liabilities ratioBased on the low percentage results of the ratio, the lending officer concludesthat the company must be allowed to pay off the loan over several more years anddecides not to call the loan

Cautions: The primary problem with this ratio is its assumption that all of thefunds needed to pay down debt are located in the noncurrent assets portion of thebalance sheet In reality, there is no reason why a relatively cash-flush entityshould not have put a large amount of cash in its short-term marketable securitiesaccount, which would not be counted in this ratio In order to include this extrasource of funds, the current assets should be netted against all current liabilities,and then any excess current liabilities included in the numerator of the ratio

Another problem with this ratio is that it assumes a lender will require a plete pay-down of its long-term debt with immediately available assets, whichmost companies will not have Instead, they count on a continuing stream of fundsfrom ongoing operations to pay down the debt.

com-A third issue is that the valuation of the noncurrent assets listed in the nominator may bear little comparison to their actual resale values; for example,

de-a compde-any could liquidde-ate its fixed de-assets de-and obtde-ain fde-ar less cde-ash from the trde-ans-action than the listed book value would indicate Consequently, using the bookvalue of the long-term assets to determine the amount of funding available to paydown long-term debt may not reflect a company’s actual ability to pay off thedebt

trans-SHORT-TERM DEBT TO LONG-TERM DEBT RATIO

Description: The ratio of short-term debt to long-term debt reveals the proportion

of total debt that is coming due for payment in the near term It can be indicative

of a company’s inability to roll its short-term debt forward into longer-term debtinstruments, which in turn indicates a lack of confidence in a company’s ability topay its debts

Formula: Divide total short-term debt by total long-term debt The short- andlong-term payment amounts due on leases should be included in the calculation inorder to include all possible types of debt The formula is:

Total short-term debtTotal long-term debt

Example: The Guttering Candle Company, maker of beeswax candles, has plied to the First National Industrial Bank for a loan The loan officer’s review ofGuttering Candle’s balance sheet for the past three years includes the informationshown in Table 5.13

ap-The table shows that the company appears to have been unable to convert itsshort-term debt into long-term debt, so its long-term debt has gradually declinedover time, whereas its short-term debt has increased This can indicate that otherlenders have turned down the company’s loan application in the past The loan of-

ficer decides to review the company’s ability to pay off loans with great care fore issuing any funds.

be-Cautions: The ratio may not make much difference if a company has such astrong cash flow that it can easily fund any reasonable amount of short-term debt

It can also be misleading if a debt balloon payment has recently shifted from thelong-term debt category to the short-term category, although a company must bemaking arrangements to roll forward the balloon payment if it does not expect topay it off in the short term

One can review this measurement more appropriately by combining it with anexamination of its available borrowing base If this ratio shows a large proportion

of short-term debt coming due, but there is a large amount of available borrowingbase, then it is reasonable to assume that the company can obtain additional fi-nancing, up to the amount of the available borrowing base, to shift debt to thelong-term category

ALTMAN’S Z-SCORE BANKRUPTCY PREDICTION FORMULA

Description: The Z-score bankruptcy predictor combines five common businessratios, using a weighting system that was statistically calculated by Dr EdwardAltman to determine the likelihood of a company going bankrupt at some point inthe future It was derived based on data from manufacturing firms, but has sinceproven to be highly effective in determining the risk that a service firm will gobankrupt The calculation can also be used by a lender to determine the credit-worthiness of a company

If the calculation results in a score above 2.99, a company is probably in safefinancial condition A score between 3.0 and 2.7 is a gray area, indicating that acompany is in acceptable condition at the moment but could slide into a more dif-ficult financial condition in the future A score between 2.7 and 1.8 indicates that

a company will probably be bankrupt within two years Any score below 1.8 dicates a high risk of bankruptcy in the near future

in-Formula: Add together the following five ratios, multiplied by the indicatedweighting factors:

1 Return on total assets ×3.3 weighting factor

2 Sales to total assets ×0.999 weighting factor

3 Equity to debt ×0.6 weighting factor

4 Working capital to total assets ×1.2 weighting factor

5 Retained earnings to total assets ×1.4 weighting factor

The formula, using more detailed derivations for each of these ratios, is:

(Operating income / Total assets) ×3.3

+(Sales / Total assets) ×0.999

+(Market value of common stock + Preferred stock) / (Total liabilities) ×0.6

+(Working capital / Total assets) ×1.2

+(Retained earnings / Total assets) ×1.4This derivation of the Z-score uses weighting factors that are applicable topublicly held companies If one is calculating the score for a privately held com-pany, the weighting factors change slightly, and are:

Return on total assets ×3.1 weighting factor

Sales to total assets ×0.998 weighting factor

Equity to debt ×0.42 weighting factor

Working capital to total assets ×0.71 weighting factor

Retained earnings to total assets ×0.84 weighting factor

Example: Calculate the Z-score for the Children’s Furniture Factory, using the formation in Table 5.14

in-The calculation is:

($25,000 Operating income / $960,000 Total assets) ×3.3 = 0.09

+($1,000,000 Sales / $960,000 Total assets) ×0.999 = 1.04

+($485,000 Market value of stock) / ($705,000 Total liabilities) ×0.6 = 0.41

+($175,000 Working capital / $960,000 Total assets) ×1.2 = 0.22

+($180,000 Retained earnings / $960,000 Total assets) ×1.4 = 0.19

When these calculations are summarized, we arrive at the Z-score shown inTable 5.15.

With a low score of only 1.95, the Children’s Furniture Factory should not be

in business much longer

Cautions: The results of this calculation are reliable only if there is no fraudulentfinancial reporting by a company that results in a higher Z-score than would oth-erwise be the case Also, a sudden downturn in the economy, or some other factorimpacting profits, such as a price war, can send a company’s financial conditionspiraling downward, irrespective of a high Z-score

Table 5.15

Weighted return on total assets ratio 0.09

Weighted sales to total assets ratio 1.04

Weighted working capital to total assets ratio 0.22

Weighted retained earnings to total assets ratio 0.19

re-The measurements discussed in this chapter are:

Times Interest Earned

Debt Coverage Ratio

Asset Quality Index

Accruals to Assets Ratio

Times Preferred Dividend Earned

Debt to Equity Ratio

Funded Capital Ratio

Retained Earnings to Stockholders’ Equity

Preferred Stock to Total holders’ Equity

Stock-Issued Shares to Authorized Shares

TIMES INTEREST EARNED

Description: An investor or lender should be interested in a company’s ability topay its debts The times interest earned ratio reveals the amount of excess fundingthat a company still has available after it has paid off its interest expense If thisratio is close to one, then the company runs a high risk of defaulting on its debt,whereas any higher ratio shows that it is operating with a comfortable amount ofextra cash flow that can cushion it if its business falters

Formula: Divide the average interest expense by the average cash flow Cash flow

is a company’s net income, to which all noncash expenses (such as depreciation

and amortization) have been added back This ratio should be run on a monthlybasis rather than annually, since short-term changes in the amount of debt carried

or cash flow realized can have a sudden and dramatic impact on it The formula is:

Average cash flow

———————————

Average interest expense

Example: The Cautious Bankers Corporation (CBC) is investigating the bility of lending money to the Grasp & Sons Door Handle Corporation (GSR).Table 6.1 shows the information CBC has collected for the last few months onGSR’s operations

possi-The table reveals that, although GSR’s interest expense is dropping, its cashflow is dropping much faster so that the company will soon have difficulty meet-ing its interest payment obligations The CBC examiner elects to pass on provid-ing the company with any additional debt

Cautions: This ratio assumes that there is no ongoing or balloon principal ment on debt; any such principal payments can greatly exceed the amount of cashoutflow required by interest payments, and so must also be factored into the de-termination of a company’s ability to pay its debt Though many companies sim-ply roll over expiring debt into new debt instruments, it is not always possible forthose in difficult financial situations

pay-DEBT COVERAGE RATIO

Description: A key solvency issue is the ability of a company to pay its debts.This can be measured with the debt coverage ratio, which compares reported earn-ings to the amount of scheduled after-tax interest and principal payments to see ifthere is enough income available to cover the payments If the ratio is less thanone, it indicates that a company will probably be unable to make its debt pay-ments The measure is of particular interest to lenders, who are concerned about acompany’s ability to repay them for issued loans

Formula: Divide the scheduled amount of principal payments by the inverse ofthe corporate tax rate This yields the amount of after-tax income required by acompany to pay back the principal Then add the interest expense to be paid, anddivide the sum into the net amount of earnings before interest and taxes An alter-native treatment of the numerator is to use earnings before interest, taxes, depre-ciation, and amortization, because this yields a closer approximation of availablecash flow The formula is:

Earnings before interest and taxes

to be $18,500 The tax rate is 34% Upcoming principal payments will be $59,000.The controller uses the following debt coverage calculation to see if Christmasbonuses can still be paid:

Earnings before interest and taxes

Cautions: The primary difficulty with this measurement is that it is focusedstrictly in the near term It is usually derived from information contained withinthe financial statements, which report earnings on an historical basis, but gives noview of expected earnings levels, which may be considerably different Conse-quently, it is best to accompany this measurement with another one that includesbudgeted earnings levels for the next few earnings periods, which gives better in-sight into a company’s ability to pay its debts

ASSET QUALITY INDEX

Description: The asset quality index is an excellent measurement for locatingcompanies that are capitalizing an increasing proportion of their costs over time,which can be a sign of changes in accounting methods that are designed to show

an increased level of profitability than is really the case Capitalization of costsmost obviously occurs in the fixed assets area of the balance sheet but can also befound in the accounts receivable and inventory areas, by means such as overload-ing of allocated overhead costs and reducing reserves for bad debt or obsolete in-ventory A measurement result of one is normal, while anything substantiallybelow that figure is indicative of either financial distress or a push to increase thelevel of reported earnings above their rightful level

Formula: Add together the current assets and net fixed assets in period two, vide them by total assets in the same period, and subtract the result from one Thenrun the same calculation for period one, and divide the result for period one intothe result for period two The formula is:

di-Current assets in period two + Net fixed assets in period two

1 – —————————————————————————

Total assets in period two

—————–——————————————————————Current assets in period one + Net fixed assets in period one

1 – —————————————————————————

Total assets in period one

Example: Glass Lamination International, a publicly held maker of rear-viewmirrors for cars, appears to be having difficulty achieving its profit estimates Aninvestment analyst chooses to use the asset quality index to see if there is evidencethat the company is shifting expenses into its fixed assets in order to bolster its re-ported earnings The relevant information is shown in Table 6.2:

1 – —————————————————————————

Total assets in period one

$1,350,000 Period two current assets + $7,700,000 Period two fixed assets

—— = 64% Asset quality index0.28

Cautions: The measurement can yield incorrect results if a company has switchedfrom the use of operating leases to capital leases, since this change in financingwill shift assets onto the balance sheet that were already in use but which werepreviously owned by a lessor For example, a manager may choose to swap out acopier that was used under an operating lease for one that the company ownsunder a capital lease; the nature of the asset has not changed, but the owner has,

so the amount of fixed assets on the company’s books will increase

The measurement can also be altered by a change in the capitalization limit Forexample, the company controller may request an increase in the capitalizationlimit, from $1,000 to $2,000, so that the accounting staff will not have so great anasset-tracking burden By doing so, the company records fewer fixed assets, eventhough its spending habits have not changed at all

The measurement can also be altered by changes in the depreciation calculationfor fixed assets because the measurement records fixed assets net of depreciation.For example, if a company were to lengthen the period over which it depreciatesassets, increase their assumed salvage values, or switch from accelerated tostraight-line depreciation, the result would be less overall depreciation beingcharged against assets and an increase in the proportion of assets in later periods,assuming that assets continue to be purchased at a steady pace

ACCRUALS TO ASSETS RATIO

Description: A key solvency issue for an outside investigator, such as an vestor, lender, or investment analyst, is the presence of any changes in accrualsover time that might be evidence of accounting tampering in order to modify acompany’s reported financial results The accruals to assets ratio can be used on atrend line to show if the proportion of accruals (a key source of possible accounting