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

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    48944
  • 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.

    b. Journalize the adjusting entries.

    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                              

     

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