Assets and Liabilities

Jacqueline Gagnon

2 Assets and Liabilities

Statement of Financial Position Fundamentals

Jacqueline Gagnon

Ratios

Measuring Liquidity and Solvency

A lightbulb brain in a circle—the 'think' section of the think-see-do approach.

Now that we are familiar with the basic building blocks of accounting: assets and liabilities, let’s look at how we can use these elements to evaluate companies. We may want to answer the question: has the company improved over last year or how is the company doing compared to its competitors? Financial statement ratios help us answer those questions.

Because the Statement of Financial Position tells us what the company owns and what they owe, we can evaluate whether the company is in a good position to pay back its liabilities as they come due. Let’s look at some ratios that use assets and liabilities to evaluate companies.

Liquidity

LiquidityLiquidity:
A company’s ability to pay current obligations as they come due. Evaluated using the current ratio or quick ratio. describes a company’s ability to pay its short-term obligations as they come due. A good rule of thumb is that a liquidity ratio should be around 2, but this depends on a company’s industry and life stage. We’ll work on two liquidity ratios: current and quick.

Current Ratio

The current ratioCurrent Ratio:
A liquidity ratio that communicates the ability of a company to repay its liabilities in the short term. Calculated as current assets divided by current liabilities. A higher current ratio indicates that a company is highly liquid. Typically, a good ratio would be around 2, but it depends on a variety of factors. tells us how easily a company can repay its current liabilities as they come due. A company with a greater current ratio has an easier time paying its obligations. For example, if a company has $100,000 in current assets and owes $50,000 in current liabilities, this company has a current ratio of 2:1. Its current assets are twice as high as its current liabilities.

$\begin{equation*} \textbf{Current Ratio}\;=\;\dfrac{\text{Current Assets}}{\text{Current Liabilities}} \end{equation*}$

Quick Ratio

The current ratio is a good start and is the most common liquidity ratio used in practice. But can we pay off our current liabilities with inventory? The bank and suppliers typically want cash, not inventory. To get cash from our inventory, we must sell the inventory and then collect from our customers. This could take months!! The quick ratioQuick Ratio:
A liquidity ratio that communicates the ability of a company to repay its liabilities in the short-term using highly liquid assets. Highly liquid assets are commonly defined as current assets less inventory and prepaid expenses. The quick ratio is calculated as highly liquid assets divided by current liabilities. A higher quick ratio indicates that a company is highly liquid. Also called an acid test. solves this problem by only including the most liquid current assets.

$\begin{equation*} \textbf{Quick Ratio}\;=\;\dfrac{\text{Current Assets}-\text{Inventory}-\text{Prepaid Expenses}}{\text{Current Liabilities}} \end{equation*}$

Again, inventory has to be sold in order to make payments, so it isn’t very liquid. Another current asset that can’t be directly used to pay current liabilities is prepaid expenses. For example, rent paid for in advance will be settled in goods or services, not cash. We can’t pay our liabilities with prepaid rent!

For both current and quick ratios, a higher ratio signals greater liquidity. Which liquidity ratio should you choose? Each ratio gives us a glimpse into how efficiently the company uses current assets, and its liquidity risk. Think of ratio analysis as investigation. The more proof we can gather, the better. So, using two ratios gives us more insight to build a case for either (a) how a company’s liquidity has changed over time or (b) how one company’s liquidity compares to its competitors.

Solvency

SolvencySolvency:
A company’s ability to pay its liabilities in the long-term. Evaluated using debt-to-total-assets ratio. is a similar concept, but describes the company’s ability to repay its total liabilities. Debt to total assetsDebt-to-Total-Assets Ratio:
A solvency ratio that communicates the ability of a company to repay its liabilities in the long-term. Calculated as total assets divided by total liabilities. A lower debt-to-total-assets ratio indicates that a company is highly solvent. Typically, a good debt-to-assets ratio would be around 0.5, but it depends on a variety of factors. is a solvency ratio. Notice that, contrary to the liquidity ratios, liabilities are in the numerator. So, a low solvency ratio means a company is able to easily pay off its total liabilities as they come due. As a rule of thumb, a ratio around 0.5 or 1:2 is preferable. As with the current ratio, this rule of thumb means that assets are twice as high as liabilities.

$\begin{equation*} \textbf{Debt‑to‑Total‑Assets}\;=\;\dfrac{\text{Total Liabilities}}{\text{Total Assets}} \end{equation*}$

Again, solvency improves as assets increase in proportion to liabilities, therefore a lower ratio indicates greater ability to pay back debt or greater solvency.

When we analyse ratios, we can compare two companies or compare one company year-over-year. Let’s see how we can calculate liquidity and solvency to determine (a) which company is in a better position to repay its current and total liabilities; or (b) whether a company has improved their position over the previous year. On the next page, there are two questions. I’ll perform ratio analysis for the first one, and you’ll get a chance to do the second.