The Pathways Model introduced in Chapter 1 indicates that
accounting is designed to provide information that helps users of
the accounting information make good decisions. Among the more
important uses of accounting information is to evaluate a company’s
business prospects, often for the purpose of making an investment
decision. Two important aspects of evaluating the financial
position of a business is to evaluate the business’ profitability
and liquidity. Below we present basic tools for evaluating
profitability and liquidity.
MEASURES OF PROFITABILITY
The $39,942 net income figure reported in Overnight’s income statement is more meaningful when examined in the context of management’s ability to control costs or when measured relative to the company’s shareholders’ equity.
Two commonly used measures of profitability that address these issues are the net income percentage and return on equity. Using data from Overnight’s financial statements, these measures are computed as follows.
All companies must incur costs in order to generate revenue. The net income percentage is simply a measure of management’s ability to control these costs. In 2018, Overnight was able to convert 22.8 percent of its revenue into net income; thus, it incurred approximately 78 cents in costs for every dollar of revenue it generated.
Return on equity is a measure of net income relative to average stockholders’ equity throughout the year. In 2018, Overnight’s average stockholders’ equity was $92,971 (i.e., the average of its beginning stockholders’ equity of $80,000, and its ending stockholders’ equity of $105,942). Thus, the company earned income of approximately 43 cents on every dollar of equity capital.
MEASURES OF LIQUIDITY
At the end of 2018, Overnight’s balance sheet reports liabilities of $20,250, most of which will require payment early in 2019. However, the balance sheet reports cash of only $18,592, which may be an indication of potential liquidity problems.
Two common measures of liquidity are a company’s working capital and its current ratio. Using data from Overnight’s financial statements, these measures are computed as follows.
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Working capital is a measure of short-term debt-paying ability expressed in dollars. Current assets represent a company’s potential cash inflows in the near future, whereas current liabilities represent cash outlays coming due soon. Overnight’s current assets exceed its current liabilities by $9,792; however, shop supplies and unexpired insurance policies are not truly liquid assets. Likewise, unearned rent revenue does not actually represent a future cash obligation.
The current ratio is simply working capital expressed as a ratio. Thus, Overnight has approximately $1.48 of potential cash inflow for every dollar of current obligations coming due. Again, this figure does not take into account that shop supplies and insurance policies will not actually convert into cash, or that unearned revenue will not actually require a future outlay of cash."
MEASURES OF PROFITABILITY
The $39,942 net income figure reported in Overnight’s income statement is more meaningful when examined in the context of management’s ability to control costs or when measured relative to the company’s shareholders’ equity.
Two commonly used measures of profitability that address these issues are the net income percentage and return on equity. Using data from Overnight’s financial statements, these measures are computed as follows.
All companies must incur costs in order to generate revenue. The net income percentage is simply a measure of management’s ability to control these costs. In 2018, Overnight was able to convert 22.8 percent of its revenue into net income; thus, it incurred approximately 78 cents in costs for every dollar of revenue it generated.
Return on equity is a measure of net income relative to average stockholders’ equity throughout the year. In 2018, Overnight’s average stockholders’ equity was $92,971 (i.e., the average of its beginning stockholders’ equity of $80,000, and its ending stockholders’ equity of $105,942). Thus, the company earned income of approximately 43 cents on every dollar of equity capital.
MEASURES OF LIQUIDITY
At the end of 2018, Overnight’s balance sheet reports liabilities of $20,250, most of which will require payment early in 2019. However, the balance sheet reports cash of only $18,592, which may be an indication of potential liquidity problems.
Two common measures of liquidity are a company’s working capital and its current ratio. Using data from Overnight’s financial statements, these measures are computed as follows.
Image
Working capital is a measure of short-term debt-paying ability expressed in dollars. Current assets represent a company’s potential cash inflows in the near future, whereas current liabilities represent cash outlays coming due soon. Overnight’s current assets exceed its current liabilities by $9,792; however, shop supplies and unexpired insurance policies are not truly liquid assets. Likewise, unearned rent revenue does not actually represent a future cash obligation.
The current ratio is simply working capital expressed as a ratio. Thus, Overnight has approximately $1.48 of potential cash inflow for every dollar of current obligations coming due. Again, this figure does not take into account that shop supplies and insurance policies will not actually convert into cash, or that unearned revenue will not actually require a future outlay of cash."
- What methods would you suggest to a company to increase their liquidity and profitability? Consider the factors: net income percent, return on equity for the profitability, and current assets or liabilities for the liquidity.
- Explain the significance of measuring a company’s return on equity.
