The Cash Flow On Total Assets Ratio Is Calculated By Four Critical Financial Ratios

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Four Critical Financial Ratios

Most startups fail due to financial problems. Potential investors are well aware of this.

Just as a ship’s captain places lookouts on deck to look for signs of danger, an entrepreneur should use several financial indicators to determine whether a business is going aground. These ratios exist to measure and assess the status quo, and we review some key ratios in this document.

By using these instruments, suboptimal outcomes can be predicted and possibly avoided.

Overview of assets and liabilities

Balance sheets categorize a company’s assets as either current assets or long-term assets. Current assets are expected to benefit the business in the next year. Fixed assets provide benefits for more than one year.

An example of a current asset could be a certificate of deposit with a maturity of six months. A long-term asset can be a machine that is expected to operate for many years.

A company usually has few assets other than cash on its balance sheet. A company can invest its money in financial instruments such as money market accounts, certificates of deposit or US Treasury bills. Because these investments can be quickly converted into cash, general accounting practice considers them cash equivalents. Cash and cash equivalents are considered short-term assets.

Similarly, a company has current liabilities and long-term liabilities. Current liabilities are those that are due in the next year. Long-term liabilities are those that will be repaid over several years.

Return of property

One common measure of a company is return on assets (ROA). Return on assets helps a potential investor gain insight into how profitably a company is using its assets.

If Company A shows an ROA of 9%, while Company B shows a 23% ROA, we see that Company B is making a much higher return on its assets. A higher ROA could indicate a competitive advantage that makes Company B an attractive investment. In contrast, if you own Company A, you would do well to examine how your competition produces more profit per dollar of assets.

The ROA formula is:

ROA = net income / average total assets

Net income can easily be found in a company’s income statement. Average total assets are calculated by adding the value of total assets at the beginning of the year to the value of total assets at the end of the year. Divide that sum by two.

Debt ratio

The more debt a company takes on, the more likely it is that the company will not be able to pay that debt. The leverage ratio shows the percentage of assets that are financed by liabilities. The debt ratio formula is:

Debt ratio = total liabilities / total assets

In the spring of 2017, Exxon Mobile had a debt ratio of 49% (162,989.00/330,314.00). The other 51% is financed by the company’s shareholders. By comparison, BP has a debt ratio of 64%. If there is an economic downturn and less sales, which of these companies is more likely to default on their debts?

Current ratio

More immediate are current liabilities that the company has: liabilities that must be paid within the next year. The current ratio gives investors insight into a company’s ability to pay its short-term obligations. To do this, we use the following formula:

Current ratio = Total current assets / Total current liabilities

The higher the ratio, the stronger the financial condition. Using the output of wood flooring company Lumber Liquidators, we get a current ratio of 8.86. This ratio reveals that for every $1.00 of current debt that lumber liquidators have to pay off in the next year, there is $8.86 available!

On the other hand, at the time of this writing, American Airlines has a current ratio of 0.76, meaning that the company has only seventy-six cents for every dollar of debt it has to pay off in the next year. One company is clearly struggling more than the other to pay its bills.

Acid test ratio (i.e. quick ratio)

The acid-test ratio is a more refined version of the current ratio. Total current assets used in the current ratio are not always easy to convert into cash (if the company needs to pay off debt quickly). It is significant that supplies are excluded when the acid-test is used. The formula is:

Acid-Test = Cash and Equivalents + Market. Securities + accounts. Receivables / Total short-term liabilities

When we retest Lumber Liquidators with the acid test ratio, we get a value of 0.22 – a much weaker result than the current ratio. There are several interesting implications here. Lumber Liquidators is a company whose current value comes primarily from its inventory. He has relatively little cash. A smart investor can take that information and try to imagine situations in which a company with a large inventory might suffer, and then estimate the likelihood of those episodes occurring.

American Airlines, whose current assets rely less on inventory and more on cash and receivables, has a sour ratio of 0.90.

Conclusion

Cash is the lifeblood of business. Even when sales are good, business owners often seek additional financial resources for business development – from debt or equity. The information presented in the balance sheet, income statement and cash flow statements are crucial for outside investors to decide whether to provide that money to the company. The ratios presented here provide operational insight not only for potential investors, but also for current business owners.

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