Understanding Business Accounting For Dummies, 2nd Edition (129 page)

Analysing cash flow from
loss
(instead of from profit) is very important. When a company reports a loss for the year - instead of a profit - an immediate question is whether the company's cash reserve will buy it enough time to move out of the loss column into the profit column. When a business is in a loss situation (the early years of a start-up business, for example) and its cash flow from operating activities is negative, focus on the company's cash balance and how long the business can keep going until it turns the corner and becomes profitable. Stock analysts use the term
burn rate
to refer to how much cash outflow the business is using up each period. They compare this measure of how much cash the business is haemorrhaging each period to its present cash balance. The key question is this: Does the business have enough cash on hand to tide it over until it starts to generate positive cash flow from profit, and if not, where will it get more money to burn until it can record a profit?

Are Increases in Assets and Liabilities Consistent with the Business's Growth?

Publicly-owned businesses present their financial statements in a three-year comparative format (or sometimes a two-year comparative format). Strictly speaking, the language of GAAP does not require comparative financial statements - although all businesses, private and public, are encouraged to present comparative financial statements. Furthermore, business investors and lenders demand comparative financial statements. Thus, three columns of numbers are reported in profit and loss accounts, balance sheets, and cash flow statements - for the years 2009, 2008, and 2007, for instance. To keep financial statement illustrations in this book as brief as possible, we present only one year; we do not include two additional columns for the two previous years. Please keep this point in mind.

Presenting financial statements in a three-year comparative format, as may be obvious, helps the reader make year-to-year comparisons. Of course, you have to deal with three times as many numbers in a three-year comparative financial statement compared with a one-year financial statement. And we should point out that the
amounts of changes
are not presented; you either eyeball the changes or use a calculator to compute the amounts of changes during the year. For example, the ending balances of a business's property, plant, and equipment asset account may be reported as follows (in millions of pounds): £4,097, £4,187, and £3,614 for the fiscal years ending in 2009, 2008, and 2007. Only these ending balances are presented in the company's comparative balance sheet - the increase or decrease during the year is not presented.

A three-year comparative format enables you to see the general trend of sales revenue and expenses from year to year and the general drift in the amounts of the company's assets, liabilities, and owners' equity accounts. You can easily spot any major differences in each line of the cash flow statement across the years. Whether you just cast a glance at adjacent amounts or actually calculate changes, ask yourself whether the increases of a company's assets and liabilities reported in its balance sheet are consistent with the sales growth of the business from year to year.

Unusually large increases in assets that are greatly out of line with the company's sales revenue growth put pressure on cash flow and could cast serious doubts on the company's solvency - which we explain in the next section.

Are There Any Signs of Financial Distress? Will the Business Be Able to Pay Its Liabilities?

A business can build up a good sales volume and have very good profit margins, but if the company can't pay its bills on time, its profit opportunities could go down the drain.
Solvency
refers to the prospects of a business being able to meet its debt and other liability payment obligations on time. Solvency analysis asks whether a business will be able to pay its liabilities, looking for signs of financial distress that could cause serious disruptions in the business's profit-making operations. In short, even if a business has a couple of billion quid in the bank, you should ask: How does its solvency look?

To be solvent does not mean that a business must have cash in the bank equal to its total liabilities. Suppose, for example, that a business has £2 million in non-interest-bearing operating liabilities (mainly creditors and accrued expenses payable), £1.5 million in overdraft (due in less than one year), and £3.5 million in long-term debt (due over the next five years). Thus, its total liabilities are £7 million. To be solvent, the business does not need £7 million in its bank account. In fact, this would be foolish.

There's no point in having liabilities if all the money were kept in the bank. The purpose of having liabilities is to put the money to good use in assets other than cash. A business uses the money from its liabilities to invest in
non-cash
assets that it needs to carry on its profit-making operations. For example, a business buys products on credit and holds these goods in stock until it sells them. It borrows money to invest in its fixed assets.

Solvency analysis asks whether assets can be converted quickly back into cash so that liabilities can be paid on time. Will the assets generate enough cash flow to meet the business's liability payment obligations as they come due?

Short-term
solvency analysis looks a few months into the future of the business. It focuses on the
current
assets of the business in relation to its
current
liabilities; these two amounts are reported in the balance sheet. A rough measure of a company's short-term liability payment ability is its
current ratio
- current assets (cash, debtors, stock, and prepaid expenses) are divided by current liabilities (creditors and accrued expenses payable, plus interest-bearing debt coming due in the short term). A 2-to-1 current ratio usually is a reasonable benchmark for a business - but don't swallow this ratio hook, line, and sinker.

A 2-to-1 current ratio is fairly conservative. Many businesses can get by on a lower current ratio without alarming their sources of short-term credit.

Business investors and creditors also look at a second solvency ratio called the
quick ratio
. This ratio includes only a company's
quick assets
- cash, debtors, and short-term marketable investments in other company shares (if the company has any). Quick assets are divided by current liabilities to determine the quick ratio. It's also called the
acid-test ratio
because it's a very demanding test to put on a business. More informally, it's called the
pounce ratio
,
as if all the short-term creditors pounced on the business and demanded payment in short order.

Many people consider a safe acid-test ratio to be 1-to-1 - £1 of quick assets for every £1 of current liabilities. However, be careful with this benchmark. It may not be appropriate for businesses that rely on heavy short-term debt to finance their inventories. For these companies, it's better to compare their quick assets with their quick liabilities and exclude their short-term notes payable that don't have to be paid until stock is sold.

The current and acid-test ratios are relevant. But the solvency of a business depends mainly on the ability of its managers to convince creditors to continue extending credit to the business and renewing its loans. The credibility of management is the main factor, not ratios. Creditors understand that a business can get into a temporary bind and fall behind on paying its liabilities. As a general rule, creditors are slow to pull the plug on a business. Shutting off new credit may be the worst thing lenders and other creditors could do. This may put the business in a tailspin, and its creditors may end up collecting very little. Usually, it's not in their interest to force a business into bankruptcy, except as a last resort.

Are There Any Unusual Assets and Liabilities?

Most businesses report a miscellaneous, catch-all account called
other assets
.
Who knows what might be included in here? If the balance in this account is not very large, trust that the auditor did not let the business bury anything important in this account.