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Acid-test Ratio. The acid-test ratio is:
Cash + Accounts receivable + Marketable securities
Current liabilities

In A.I.™s case, that™s
$1,271,231 + $994,409 + $0 $2,265,640
= $.89 : $1
$2,538,539 $2,538,539
The acid-test ratio shows how well a company could pay its
current debts using only its most liquid or “quick” assets. This is
a more pessimistic”but also realistic”measure of safety than
the current ratio, because it ignores sluggish, hard-to-liquidate
current assets like inventory and notes receivable.
Instead, it adds up the three most liquid assets a business has:

cash (which is as liquid as you can get), accounts receivable (which
will probably be collected in a month or so), and marketable
securities (which could probably be sold with a telephone call).
A.I. seems to be fairly solid by this measure, too, with 89
cents in highly liquid assets standing behind each $1 it owes in
current debts. If its acid-test ratio was, say, $1.50 : $1 and much
of it was in cash, management might think about putting some
of that cash to work by investing it in facilities or equipment,
enhancing the company™s marketing efforts, or doing something
else to make more profit for stockholders.
If it were low, like $.5 : $1, management should worry. How™s
the company going to weather a quick, unforeseen storm?
Ratio of Debt to Stockholders™ Equity. This calculation
shows which group”creditors or stockholders”has the biggest
stake in or the most control of the company. Observe:
Total liabilities $ 5,438,539
= = $.39 : $1
Stockholders™ equity $14,095,951

Creditors have 39 cents of claims against the company for
each $1 of stockholders™ claims.
A ratio of $1 to $1 would mean the company is worth as
much to outsiders (creditors) as it is to its owners, which wouldn™t
be good news if you were a stock-
BT est holder. In fact, it would mean that
management is actually working
half of every day for the com-
A healthy company has a
ratio of debt to equity of 1 : 2 pany™s creditors.What a miserable
or better.
A high ratio here means that
the company is heavily financed
with debt (most likely bonds or long-term loans), which also
means it™s probably paying through the nose in interest each
year”not to mention that the debt is going to come due some-
But good old A.I. is worth more than twice as much to stock-
Financial Analysis: Number-Crunching for Profit 57

holders than to creditors, which should make the stockholders
happy. And happy stockholders mean that the top managers can
probably feel safe trading in last year™s Mercedes on a new model
or adding a third vacation home.
Book Value of Common Stock. This is the theoretical
amount per share that each stockholder would receive if the
company™s assets were sold on the balance sheet date. How much
would that be if you were an A.I. stockholder?
Stockholders™ equity $14,095,951
= $5.64
Common stock shares outstanding 2,500,000
So that™s $5.64 per share. When the book value of a company™s
common stock is higher than its market value, investors usually
consider the stock a good buy. A book value that™s considerably
less than market value, however, suggests that the stock may be
overpriced on the market.
That doesn™t necessarily mean that investors are being taken
for a ride, however. Investors who are optimistic about a
company™s financial future may be perfectly willing to pay lots
more for the stock on the open market than they™d get if the
company were sold. But the greater the gap between book value
and market value, the greater the risk.

Calculations That Use Data from Both Statements
Some calculations pull one figure off the income statement
and one off the balance sheet. Calculators at the ready? Begin!
Rate of Return on Stockholders™ Equity. This tells you
how much profit management made on each dollar that stock-
holders invested in the company.
Net income = $ 1,509,601 = .107 = 11 percent
Stockholders™ equity $14,095,951
So A.I. made 11 cents (or 11 percent) this year on each of its
stockholders™ dollars. Again, it™s important to have a comparative
figure for companies in the same industry as A.I.

A high return suggests that management is doing a good job
of managing the stockholders™ investment. A low rate of return
means that stockholders might
BT consider investing their funds in
ip some other company”or having
the managers who are responsible
If the book value of a com-
for such lousy perfor mance
pany™s common stock is less
stoned publicly.
than its market value, investors
If a company™s return on eq-
are paying more to own a
uity is low, and the company is
share than they™d get if the
top-heavy with cash, manage-
company were liquidated.
ment should put that excess cash
to work to improve the return.
In A.I.™s case, stockholders who aren™t satisfied with an 11 per-
cent return should find someplace else to put their portions of
the $14,095,951.
Keep in mind that return on equity changes every year as a
company™s net income changes.
Rate of Return on Total Assets. This calculation tells stock-
holders and creditors how well management is managing the
company™s assets. So we go shopping in the income statement
and balance sheet to find:
Net income $ 1,509,601
= .077 = 8 percent
Total assets $19,534,490
A.I.™s management made about eight cents on each dollar™s
worth of assets this year. Is that good or bad? Once again, we
don™t know until we get a comparative figure for companies in
the same industry. As with rate of return on stockholders™ equity,
a high figure suggests a good job; a low figure a not-so-good
Number Of Days Sales in Receivables. This is the corpo-
rate form of bondage, but not nearly as kinky. It shows how
many days™ worth of net sales are tied up in credit sales (ac-
counts receivable) that haven™t been collected yet. Sometimes
Financial Analysis: Number-Crunching for Profit 59

this is called the average collection period. It can be figured in
two steps.
Step 1: Figure average credit sales per day (let™s assume that all
A.I.™s sales are on credit):
Net sales
= $38,028,500 = $104,188 average sales per day
365 days 365

Step 2: Figure number of days sales tied up in receivables:
$994,409 accounts receivable
= 9.5 days
$104,188 average sales per day
The more days™ worth of sales a company has tied up in ac-
counts receivable, the worse things look. That™s because the longer
a debt goes uncollected, the greater the odds that it won™t be
collected. Any flinty-eyed corporate credit manager will tell you
Also, a lengthy collection period gives rise to that painful
condition known as “paper profitability.” Your income statement
looks pretty good, but you don™t actually have the money yet for
the goods you™ve sold. More than a few “profitable” companies
have gone down the tubes wait-
ing for the money to come in. est
(Which is why watching cash
flow is so important.) A company with a long
A.I. is taking a mere 9.5 days average collection period is
to collect each credit sale. Because
probably selling to marginal
companies usually give credit cus-
credit customers and/or not
tomers 30 to 60 days maximum
working hard enough to
to pay their bills (except for some
collect past-due balances.
industries like the grocery busi-
ness, where 5 to 7 days is the
norm), A.I. is collecting from credit customers very fast, which
is very good.
That implies that the company™s credit manager isn™t approv-
ing open-book accounts to many slow pay/no-pay/day-late-and-

Best Tip a-dollar-short customers. He may,
in fact, be running them off at
gunpoint for even having the guts
A long collection period may
to ask. Moreover, the company is
mean you™re profitable on
probably offering cash discounts
paper”while you™re sinking
for early payment, which moti-
vates customers to pay up pronto.
If the number of days sales tied
up in receivables were, say, 35 or 40, management should probably:
Be much more choosy about the companies A.I. sells to on

Consider offering cash discounts to encourage customers

to pay their bills earlier than necessary.
Pursue deadbeat accounts more aggressively to collect past-

due balances.
Encourage the credit manager to update his or her r©sum©

and start applying for work with competitors.
As with many other financial-analysis calculations, a com-
parative figure for the industry will put this calculation in a bet-
ter perspective.

Try a Little Vertical Analysis
Vertical analysis shows how a company™s condition changed
from one year to the next. It compares the statements top to
bottom for the past two years by expressing their key amounts
as percentages of a base figure (100 percent).
When you analyze an income statement vertically, net sales is
usually used as the base. On a balance sheet, total assets are the
base for the assets side and the sum of liabilities and stockhold-
ers™ equity is the base for those elements.
Vertical analysis can show you:
If cost of goods sold increased or decreased since last year.

Whether gross profit increased or decreased from last year.

(Note: If cost of goods sold increased, gross profit auto-
Financial Analysis: Number-Crunching for Profit 61

matically decreased. If cost of goods sold decreased, gross
profit automatically increased.)
Whether the company made more or less profit as a per-

centage of net sales from last year to this year.
Which factors (cost of goods sold, expenses, or both) com-

bined to make the company™s net income a higher or lower
percentage of net sales than it was last year.
Whether selling and general-and-administrative expenses

increased or decreased as a percentage of net sales.
How much income tax the company pays as a percentage

of net sales.
The percentage change in the company™s current and prop-

erty and equipment assets (as a percentage of total assets)
from last year to this year.
The percentage change in the company™s current and long-

term liabilities (as a percentage of liabilities and stockhold-


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