The condensed financial statements of Underwood Company for the years 2019 and 2020 are presented as follows. (Amounts in thousands.) UNDERWOOD COMPANY Balance Sheets December 31 2020 2019 Current assets Cash and cash equivalents $330 $360 Accounts receivable (net) 470 400 Inventory 460 390 Prepaid expenses 120 160 Total current assets 1,380 1,310 Investments 10 10 Property, plant, and equipment 420 380 Intangibles and other assets 530 510 Total assets $2,340 $2,210 Current liabilities $900 $790 Long-term liabilities 410 380 Stockholders’ equity—common 1,030 1,040 Total liabilities and stockholders’ equity $2,340 $2,210 UNDERWOOD COMPANY Income Statements For the Years Ended December 31 2020 2019 Sales revenue $3,800 $3,460 Costs and expenses Cost of goods sold 955 890 Selling & administrative expenses 2,400 2,330 Interest expense 25 20 Total costs and expenses 3,380 3,240 Income before income taxes 420 220 Income tax expense 126 66 Net income $294 $154 Compute the following ratios for 2020 and 2019. Current ratio. Inventory turnover. (Inventory on 12/31/18 was $340.) Profit margin. Return on assets. (Assets on 12/31/18 were $1,900.) Return on common stockholders’ equity. (Stockholders’ equity on 12/31/18 was $900.) Debt to assets ratio. Times interest earned.
Reporting Cash Flows
Reporting of cash flows means a statement of cash flow which is a financial statement. A cash flow statement is prepared by gathering all the data regarding inflows and outflows of a company. The cash flow statement includes cash inflows and outflows from various activities such as operating, financing, and investment. Reporting this statement is important because it is the main financial statement of the company.
Balance Sheet
A balance sheet is an integral part of the set of financial statements of an organization that reports the assets, liabilities, equity (shareholding) capital, other short and long-term debts, along with other related items. A balance sheet is one of the most critical measures of the financial performance and position of the company, and as the name suggests, the statement must balance the assets against the liabilities and equity. The assets are what the company owns, and the liabilities represent what the company owes. Equity represents the amount invested in the business, either by the promoters of the company or by external shareholders. The total assets must match total liabilities plus equity.
Financial Statements
Financial statements are written records of an organization which provide a true and real picture of business activities. It shows the financial position and the operating performance of the company. It is prepared at the end of every financial cycle. It includes three main components that are balance sheet, income statement and cash flow statement.
Owner's Capital
Before we begin to understand what Owner’s capital is and what Equity financing is to an organization, it is important to understand some basic accounting terminologies. A double-entry bookkeeping system Normal account balances are those which are expected to have either a debit balance or a credit balance, depending on the nature of the account. An asset account will have a debit balance as normal balance because an asset is a debit account. Similarly, a liability account will have the normal balance as a credit balance because it is amount owed, representing a credit account. Equity is also said to have a credit balance as its normal balance. However, sometimes the normal balances may be reversed, often due to incorrect journal or posting entries or other accounting/ clerical errors.
The condensed financial statements of Underwood Company for the years 2019 and 2020 are presented as follows. (Amounts in thousands.)
|
UNDERWOOD COMPANY |
||
|
2020 |
2019 |
|
|
Current assets |
||
|
Cash and cash equivalents |
$330 |
$360 |
|
|
470 |
400 |
|
Inventory |
460 |
390 |
|
Prepaid expenses |
120 |
160 |
|
Total current assets |
1,380 |
1,310 |
|
Investments |
10 |
10 |
|
Property, plant, and equipment |
420 |
380 |
|
Intangibles and other assets |
530 |
510 |
|
Total assets |
$2,340 |
$2,210 |
|
Current liabilities |
$900 |
$790 |
|
Long-term liabilities |
410 |
380 |
|
|
1,030 |
1,040 |
|
Total liabilities and stockholders’ equity |
$2,340 |
$2,210 |
|
|
|
UNDERWOOD COMPANY |
||
|
2020 |
2019 |
|
|
Sales revenue |
$3,800 |
$3,460 |
|
Costs and expenses |
||
|
Cost of goods sold |
955 |
890 |
|
Selling & administrative expenses |
2,400 |
2,330 |
|
Interest expense |
25 |
20 |
|
Total costs and expenses |
3,380 |
3,240 |
|
Income before income taxes |
420 |
220 |
|
Income tax expense |
126 |
66 |
|
Net income |
$294 |
$154 |
|
|
Compute the following ratios for 2020 and 2019.
Current ratio .- Inventory turnover. (Inventory on 12/31/18 was $340.)
- Profit margin.
- Return on assets. (Assets on 12/31/18 were $1,900.)
- Return on common stockholders’ equity. (Stockholders’ equity on 12/31/18 was $900.)
- Debt to assets ratio.
- Times interest earned.
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Current Ratio:
The Current Ratio is a liquidity ratio that measures a firm's ability to pay off its current liabilities with the current assets. Higher Current Ratio is favorable than a lower current ratio because it shows the company's liquidity is as good and can more easily make current debt payments. It is calculated by dividing the current assets by the current liabilities for the accounting period.
The current assets are those which can be realized within a short period of time or within an accounting period. Current assets include cash, accounts receivables, inventories, etc.
Current Liabilities are those which are paid off within an accounting period. It includes accounts payable, unearned revenue, etc.
Formula:
Current Ratio = Current Assets/Current Liabilities
Inventory Turnover Ratio:
It shows how effectively inventory is managed by comparing the cost of goods sold with the inventory for the accounting period. it measures how many times the average inventory is turned or sold. it is an important ratio because the total turnover ratio depends upon two main components of performance, Purchase, and Sale. It shows how quickly its inventory is turned to cash. Higher sales are better and so this is the ratio.
Formula:
Inventory Turnover Ratio = Cost of Goods Sold/Average Inventory
Average Inventory is calculated by adding the opening balance of inventory for the accounting period and the closing balance of the accounting period divided by 2.
Average Inventory = (Opening Inventory + Closing Inventory)/2
Profit Margin Ratio:
Creditors and investors use this ratio to measure how effectively a company can convert sales into net income. It is also known as Return on Sales Ratio or Net Profit Ratio. It measures the amount of net income earned with each dollar of sales. It measures the overall profitability of the sales. There may be a case where the company is efficient with its gross profit but the other expenses are too high to give good net income.
Formula:
Profit Margin Ratio = Net Income/Net Sales
Let us calculate the ratios as discussed above one by one:
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