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Solvency Ratios
One can learn a great deal about a company from a study of the final accounts. The features one would select for particular attention will depend on whether the results are being analysed by an investor in the company (in which case see Chapter 6), a potential supplier of goods on credit to the company, a prospective employee of the company, or a lending banker.
An important factor concerning the performance and stability of the company, not normally revealed in a balance sheet, is the accuracy of the valuation of fixed assets and of stock. The basis of valuation is usually shown (e.g. historic cost less depreciation, or current replacement cost), but there is no way in which an outsider can check how realistic the basis is in practice.
In evaluating a company's financial statements it is the proportions of certain figures to each other rather than their absolute magnitudes that matter. These are expressed as ratios, often as percentage ratios. The main ratios are described below.
A would-be creditor of the company would seek to know whether, in the reasonably short term, all the outstanding liabilities of the company could be paid off without harming the company by having to dispose of productive assets. Three ratios used for this purpose (figures in brackets refer to the above example) are as follows.
Current ratio: current assets : current liabilities
(209.5) (70.4) (= 3.0)
Liquid ratio: liquid assets : current liabilities
(56.3) (70.4) (= 0.8)
Quick ratio: (colloquially called the 'acid test')
current assets minus the stock
(or liquid assets plus debtors) : current liabilities
(121.5) : (70.4) (= 1.7)
In our example it is quite clear from the first two ratios that there is no doubt about the current solvency of this company, since the outside liabilities can be paid off three times over from current assets, and that they could almost be paid out of cash. But with a balance sheet showing a less liquid position many analysts would apply the third ratio (the 'acid test'); this is considered to be more reliable since it excludes stock in hand which might, in the event, prove difficult to realise on a forced sale.
Taxation
Provision for taxation is the amount set aside out of current profits to meet the future demands of the taxman by way of corporation tax. From the fact that the liability for tax shown in the balance sheet is the same as the amount provided from current profits one deduces that there is no outstanding provision for future liability. Sophisticated students of accountancy will realise that this cannot be true, but this pretence makes it simpler to understand for the non-tax specialist.
A Processing Co. Ltd
Trading Account for the year to 31 December, 2000
£ £
Total... see: Taxation