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

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:

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:

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.

b. Journalize the adjusting entries.

c. Journalize the closing entries.

Solution to demonstration problem

a. See the work sheet below.

b.

c.