Accounting Equation:
Assets = Liabilities + Equity.
The Expanded Accounting Equation
Assets = Liabilities + Owner Contributions – Owner Withdrawals + Revenues –
Expenses.
This equation is the basis for the entire set of financial statements. It shows what
the company owns (assets), how much debt there is (liabilities) and the components
of owners’ equity—how much have the owners invested and how much did the company add
to the owners’ wealth.
What are the equity accounts?
The equity accounts include capital contributions by the owner(s) and withdrawals.
In short, equity is the value of the owner’s investment in the business. It is made
up of all of the owner’s contributions to the business (in the form of cash) as well
as accumulated earnings that have not been distributed to the owner. In equity
accounts,capital contributions increase equity and withdrawals decrease equity
Accounting Cycle:
The accounting cycle begins with transactions and ends with completed financial
statements. The first step is to journalize the transaction. The journal is a
chronological list of each accounting transaction and includes at a minimum the
date, the accounts affected, and the amounts to be debited and credited.
Statement of Owners’ Equity
The statement of owners’ equity, or owner’s equity if the company is a sole
proprietorship, shows beginning owner capital, additions and subtractions to
capital, including net income from the Income Statement. This gives the total
owners’ capital at the end of the same specific time period as the Income Statement.
This amount will be the beginning capital for the next Statement of Owners’ Equity.
Both of the Income Statement and the Statement of Owners’ Equity, as well as the
Statement of Cash Flows, show activities over a period of time, such as a year.
Equity = Owner Contributions – Owner Withdrawals + Revenues – Expenses.
Balance Sheet
The balance sheet, unlike the previous two statements, shows a snapshot of the
business at a moment in time. Notice that the Income Statement and the Statement of
Owners’ Equity both identify the period of time covered,but the Balance Sheet
indicates a specific date that is always the last day of the time period covered by
the prior two statements. The balance sheet is based on the accounting equation and
show total assets, total liabilities, and owners’ equity, and shows as well how they
balance
Expanded ACcounting Equation:
Assets = Liabilities + (Common Stock – Dividends + Revenues – Expenses)
This expanded equation takes into consideration the components of Equity. Equity
increases from revenues and owner investments (stock issuances) and decreases from
expenses and dividends. These equity relationships are conveyed by expanding the
accounting equation to include debits and credits in double-entry form. The
increases (credits) to common stock and revenues increase equity; whereas the
increases (debits) to dividends and expenses decrease equity.
For a corporation with shareholders the accounting equation is:
Assets = Liabilities + Paid-in Capital + Revenues – Expenses – Dividends – Treasury
Stock
For a sole proprietorship or a company without shareholders the accounting equation
expands to be:
Assets = Liabilities + Owner’s Capital + Revenues – Expenses – Owner’s Draws
RATIOS:
RETURN ON INVESTMENTS:
1. Current Ratio. The current ratio measures a company’s ability to pay its current
liabilities from its current assets.
Current Ratio= (Current Assets)/(Current Liabilities)
Generally, the higher the current ratio, the stronger the financial position of the
business and typically financial analysts consider a current ratio of 2:1 to be
ensure that a business has sufficient working capital to fund ongoing operations.
2. Quick Ratio or Return on Investment (ROI). The quick ratio or return on
investment (sometimes referred to as the acid test ratio) is more conservative than
the current ratio because it does not include inventory in current assets. The quick
ratio measures a company’s ability to pay its current debts if all revenue ceased.
Quick Ratio= (Current Assets — Inventory)/(Current Liabilities)
A quick ratio of 1:1 is considered satisfactory and a ratio higher than this is an
indicator of greater financial security.
RETURN ON EQUITY:
1. Debt Ratio. The debt ratio measures the percentage of the company’s total assets
that are financed by creditors and lenders as opposed to the owners. The debt ratio
is calculated as follows:
Debt Ratio= (Total Debt or Liabilities)/(Total Assets)
2. Debt-to-Net-Worth Ratio. This ratio also expresses the relationship between the
capital contributions of the owners and the capital contributed by lenders. It is
fundamentally the ratio of what the business is worth compared to what the business
owes.
Debt-to-Net-Worth Ratio= (Total Debt or Liabilities)/(Tangible Net Worth)
3. Times-Interest-Earned Ratio. This ratio is the measure of a business’s ability to
make its interest payments on borrowed capital. In literally tells the business how
many times their earnings will cover the interest payments on the loans it is
carrying. It is calculated as follows:
Times Interest Earned Ratio= (EBIT (Earnings Before Interest &
Taxes))/(Total Interest Expense)
Return on Equity is the measure of both profit and efficiency. An increase in ROE
over time is a good thing for a business. However, some industries tend to ROEs in a
specific range so it’s important to compare companies from the same industry.
ROE= (Net Income)/(Shareholder’s Equity)
OPERATING RATIOS:
1. Average-Inventory-Turnover Ratio. This ratio measures the number of times that a
company’s inventory turns over or sells out during the accounting period. It is very
common for retail businesses to rely heavily on this ratio for obvious reasons –
their primary source of revenue is derived from selling inventory. This ratio can
also help a business determine if its inventory is obsolete, understocked or
overstocked and is calculated as follows:
Average Inventory Turnover Ratio= (Cost of Goods Sold)/(Average Inventory)
2. Average-Collection-Period Ratio. This ratio is often referred to as days sales
outstanding because it tells the business the average number of days that it takes
to collect its accounts receivable. In order to calculate this ratio a business must
first calculate its receivables turnover ratio as follows:
Receivables Turnover Ratio: ????
Average Collection Period Ratio= (Days in the Accounting
Period)/(Receivables Turnover Ratio)
3. Average-Payable-Period Ratio. This ratio measures the number of days it takes a
company to pay its accounts payable. Like the collection period ratio, we must first
calculate the Payables Turnover Ratio as follows:
Payables Turnover Ratio= Purchases/(Accounts Payable)
Then we are able to calculate the Average-Payable-Period Ratio as follows:
Average Payable Period Ratio= (Days in Accounting Period)/(Payables Turnover
Ratio)
4. Net-Sales-to-Total Assets Ratio. This ratio measures a company’s ability to
generate sales revenue based upon the assets of the business. It is a measure of
productivity but is only meaningful when compared to similar businesses or industry
benchmarks. The Net-Sales-to-Total Assets Ratio is calculated as follows:
Net Sales to Total Assets= (Net Sales)/(Net Total Assets)
PROFITABILITY RATIOS:
1. Net-Profit-on-Sales Ratio. This ratio measures a company’s profit per dollar of
sales. The ratio is expressed as a percentage and shows the percentage of each
dollar remaining after paying expenses. The ratio is calculated as follows:
Net Profit on Sales = Net Profit/Net Sales
2. Net-Profit-to-Assets Ratio. This ratio is also referred to as a return-on-assets
ratio because it measures how much profit a company is generating for every dollar
it has invested in the assets of the company. This ratio is calculated as follows:
Net Profit to Assets Ratio= (Net Profit)/(Total Assets)
3. Net-Profit-to-Equity Ratio. This ratio is often referred to as a return on net
worth ratio because it measures the owner’s return on investment (ROI). It reflects
the percentage of the owner’s investment in the business that is returned annually
via the profit of the business. It is one of the most important ratios when
evaluating the company’s overall profitability. This ratio is computed as follows:
Net Profit to Equity Ratio= (Net Profit)/(Owners Equity)