# 4.9: Analyzing and using the financial results — the current ratio

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The current ratio of 1.77:1 for The Home Depot means that it has almost twice as many current assets as current liabilities. Because current liabilities are normally paid with current assets, the company appears to be able to pay its short-term obligations easily.

In evaluating a company's short-term debt-paying ability, you should also examine the quality of the current assets. If they include large amounts of uncollectable accounts receivable and/or obsolete and unsalable inventory, even a 2:1 current ratio may be inadequate to allow the company to pay its current liabilities. The Home Depot undoubtedly does not have such a problem.

The current assets, current liabilities, and current ratios of some other companies as of the third quarter of 2001 were:

 Current Company Current Assets Current Liabilities Ratio Wal-Mart Stores, Inc. $32,620,000,000$ 32,869,000,000 .99:1 Hewlett-Packard Company 15,782,000,000 13,950,000,000 1.13:1 3M Corporation 6,556,000,000 5,006,000,000 1.31:1 General Electric Company 313,050,000,000 168,788,000,000 1.85:1 Johnson & Johnson 19,079,000,000 7,504,000,000 2.54:1

We described each of these companies earlier in the text.

As you can see from these comparisons, the current ratios vary a great deal. An old rule of thumb is that the current ratio should be at least 2:1. However, what constitutes an adequate current ratio depends on available lines of credit, the cash-generating ability of the company, and the nature of the industry in which the company operates. For instance, companies in the airline industry are able to generate huge amounts of cash on a daily basis and may be able to pay their current liabilities even if their current ratio is less than 1:1. Comparing a company's current ratio with other companies in the same industry makes sense because all of these companies face about the same economic conditions. A company with the lowest current ratio in its industry may be unable to pay its short-term obligations on a timely basis, unless it can borrow funds from a bank on a line of credit. A company with the highest current ratio in its industry may have on hand too many current assets, such as cash and marketable securities, which could be invested in more productive assets.

The next chapter describes the assumptions, concepts, and principles that constitute the accounting theory underlying financial accounting. Thus, accounting theory dictates the standards and procedures applied to the reporting of financial information in the financial statements.

Understanding the learning objectives

• Analyze transactions by examining source documents.

• Journalize transactions in the journal.

• Post journal entries to the accounts in the ledger.

• Prepare a trial balance of the accounts and complete the work sheet.

• Prepare financial statements.

• Journalize and post adjusting entries.

• Journalize and post closing entries.

• Prepare a post-closing trial balance.

• The work sheet is a columnar sheet of paper on which accountants summarize information needed to make the adjusting and closing entries and to prepare the financial statements.

• Work sheets may vary in format. The work sheet illustrated in the chapter has 12 columns—two each for trial balance, adjustments, adjusted trial balance, income statement, statement of retained earnings, and balance sheet.

• The information needed to prepare the income statement is in the Income Statement columns of the work sheet. Net income for the period is the amount needed to balance the two Income Statement columns in the work sheet.

• The information needed to prepare the statement of retained earnings is in the Statement of Retained Earnings columns of the work sheet. The ending Retained Earnings balance is carried forward to the balance sheet.

• The information needed to prepare the balance sheet is in the Balance Sheet columns of the work sheet.

• As explained in Chapter 3, adjusting entries are necessary to bring the accounts to their proper balances before preparing the financial statements. Closing entries are necessary to reduce the balances of revenue, expense, and Dividends accounts to zero so they are ready to receive data for the next accounting period.

• Revenue accounts are closed by debiting them and crediting the Income Summary account.

• Expense accounts are closed by crediting them and debiting the Income Summary account.

• The balance in the Income Summary account represents the net income or net loss for the period.

• To close the Income Summary account, the balance is transferred to the Retained Earnings account.

• To close the Dividends account, the balance is transferred to the Retained Earnings account.

• Only the balance sheet accounts have balances and appear on the post-closing trial balance.

• All revenue, expense, and Dividends accounts have zero balances and are not included in the post-closing trial balance.

• Manual systems and computerized systems perform the same accounting functions.

• The ease of accounting with a PC has encouraged even small companies to convert to computerized systems.

• A classified balance sheet subdivides the major categories on the balance sheet. For instance, a classified balance sheet subdivides assets into current assets; long-term investments; property, plant, and equipment; and intangible assets. It subdivides liabilities into current liabilities and long-term liabilities. Later chapters show more accounts in the stockholders' equity section, but the subdivisions remain basically the same.

• The current ratio gives some indication of the short-term debt-paying ability of a company.

• To find the current ratio, divide current assets by current liabilities.

Demonstration problem

This problem involves using a work sheet for Green Hills Riding Stable, Incorporated, for the month ended 2010 July 31, and performing the closing process. The trial balance for Green Hills Riding Stable, Incorporated, as of 2010 July 31, was as follows:

 GREEN HILLS RIDING STABLE, INCORPORATED Trial Balance 2010 July 31 Acct. No. Account Title Debits Credits 100 Cash $10,700 103 Accounts Receivable 8,100 130 Land 40,000 140 Buildings 24,000 200 Accounts Payable$ 1,100 201 Notes Payable 40,000 300 Capital Stock 35,000 310 Retained Earnings, 2010 July 1 3,100 320 Dividends 1,000 402 Horse Boarding Fees Revenue 4,500 404 Riding Lesson Fees Revenue 3,600 507 Salaries Expense 1,400 513 Feed Expense 1,100 540 Interest Expense 200 568 Miscellaneous Expense 800 $87,300$87,300

Depreciation expense for the month is USD 200. Accrued salaries on July 31 are USD 300.

a. Prepare a 12-column work sheet for the month ended 2010 July 31.

c. Journalize the closing entries.

Solution to demonstration problem

a. See the work sheet below.

 GREEN HILLS RIDING STABLE, INCORPORATE Work Sheet For the Month Ended 2010 July 31 Acct. Account Titles Trial Balance Adjustments Adjusted Balance Income Statement Statement of Retained Earnings Balance Sheet No. Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit 100 Cash 10,700 10,700 10,700 103 Accounts Receivable S,100 3,100 8,100 130 Land 40,000 40,000 40,000 140 Buildings 24,000 24,000 24,000 200 Accounts Payable 1,100 1,100 1,100 201 Notes Payable 40,000 40,0 0 0 40,000 300 Capital Stock 35,000 35,000 35,000 310 Retained Earnings 2010 July 1 3,100 3,100 3,100 320 Dividends 1,000 1,000 1,000 402 Horse Boarding Fees Revenue 4,500 4,500 4,500 404 Riding and Lesson Fees Revenue 3,500 3,600 3,600 507 Salaries Expense 1,400 (2) 300 1,700 1,700 513 Feed Expense 1,100 1,100 1,100 540 Interest Expense 200 200 200 563 Miscellaneous Expense 300 SOO SOO 87,300 37,300 520 Depreciation Expense—Buildings (1) 200 200 200 141 Accumulated Depreciation- Buildings (1) 200 200 200 206 Salaries Payable (2) 300 300 300 EOO 5oo 87,500 37,300 4,000 8,100 Net Income 4,100 4,100 8,100 8,100 1,000 7,200 82,300 76,600 Retained Earnings, 2010 July 31 6,200 6,200 7,200 7,200 S2,S00 32,800 Adjustments: (i) To record depreciation of building for July. (2) To record accrued salaries of \$300.

b.

 GREEN HILLS RIDING STABLE, INCORPORATED                                              General Journal                                                    Page 4 Date Account Titles and Explanation Post. Ref. Debt Credit 2010 Adjusting Entries July 31 Depredation Expense—Buildings (-SE) 520 2 0 0 Accumulated Depreciation—Buildings (-A) 141 2 0 0 To record depreciation expense. 31 Salaries Expense (-SE) 507 3 0 0 Salaries Payable (+L) 206 3 0 0 To record accrued salaries.

c.

 GREEN HILLS RIDING STABLE, INCORPORATED                                         General Journal                                                Page 4 Date Account Titles and Explanation Post. Ref. Debt Credit 2010 Closing Entries July 31 Horse Boarding Fees Revenue 402 4 5 0 0 Riding Lesson Fees Revenue 404 3 6 0 0 Income Summary 600 8 1 0 0 To close revenue accounts. 31 Income Summary 600 4 0 0 0 Salaries Expense 507 1 7 0 0 Feed Expense 513 1 1 0 0 Interest Expense 540 2 0 0 Miscellaneous Expense 568 8 0 0 Depreciation Expense—Buildings 520 2 0 0 To close expense accounts. 31 Income Summary 600 4 1 0 0 Retained Earnings 310 4 1 0 0 To close Income Summary account. 31 Retained Earnings 310 1 0 0 0 Dividends 320 1 0 0 0 To close dividends account

4.9: Analyzing and using the financial results — the current ratio is shared under a not declared license and was authored, remixed, and/or curated by LibreTexts.