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1. The cash basis of accounting measures revenues and expenses in terms of cash received or cash paid. The timing of these payments determines the period in which revenues and expenses are recorded. While such a basis appears simple and easy to follow, it unfortunately provides a distorted picture of the company's true operating performance. Using cash as the basis for accounting may delay the recording of revenue until cash is actually received (but the effort and/or duties needed to earn the revenue have already occurred). Management may also try to influence the amount and timing of the revenues and expenses by receiving or spending cash when it would appear to be most advantageous.


Accrual accounting attempts to recognize revenue in the period when the effort and/or duties occur, not when the cash moves. Likewise, accrual accounting attempts to match expenses to their revenues (recording the related expenses in the same period as the revenues). While accrual accounting is not without its own challenges (such as when the efforts are actually made or estimates of returns are needed), it provides a more accurate picture of a company's revenues and expenses.




XYZ Company

Income Statement

For the Year Ended December 31, Year 2



Cash Flow 

Sales revenue, 75% on credit



   Accounts receivable balance



      December 31, Year 1, $50,000



      December 31, Year 2, $60,000



Cost of good sold, 100% on credit



   Accounts payable balance



      December 31, Year 1, $15,000



      December 31, Year 2, $12,000






   Salaries and Wages



      Accrued wages payable balance



         December 31, Year 1, $1,500



         December 31, Year 2, $1,600



   Depreciation expense


   Rent expense



      No accruals



   Income tax expense

$ 5,500

$ (4,500)

      Taxes payable balance



         December 31, Year 1, $1,000



         December 31, Year 2, $2,000



   Total expenses

$ 35,500


Net income




Cash flow from operating activities


$ 95,100 







Financing, increase


Financing, decrease


Operating, decrease


No cash effect, added to net income using the indirect method


No cash effect





The calculation of selected financial ratios for All-Things Inc. for the fiscal year Year 6 is as follows.




Current ratio = Current assets / Current liabilities =~ $9,900 / $6,300 = 1.57




Acid-test ratio = (Cash + Marketable securities + Net receivables) / Current liabilities = ($400 + $500 + $3,200) / $6,300 = 0.65




Total asset turnover = Net sales / Average total assets = $30,500 / ($17,000+$16,000)/2 = 1.85 times




Inventory turnover = Cost of goods sold / Average inventory = $17,600 / ($5,800 + $5,400)/2 = 3.14 times




Times interest earned = Income before interest & taxes / Interest expense = ($7,060 + $900) / $900 = 8.84




Total debt to net worth = Total debt / Total shareholders' equity = $8,300 / $8,700 = 0.95




Net profit margin = Net income / Net sales = $4,160 / $30,500 = 13.64%




The analytical use of each of the seven ratios and what investors can learn about All-Things Inc.'s financial stability and operating efficiency is presented below.


Current ratio

Measures the ability to meet short-term obligations using short-term assets.

All-Things' ratio has declined over the last three years from 1.62 to 1.57. This declining trend, coupled with the fact that it is below the industry average, is not yet a major concern; however, the company should be watched in the future.


Acid-test ratio

Measures the ability to meet short-term debt using the most liquid (quick) assets; i.e., excluding the amount invested in inventory.

All-Things has improved its acid-test ratio over the last three years, but it is still below the industry average. Furthermore, an acid-test ratio below 1.0 indicates that All-Things may have difficulty meeting its short-term obligations if inventory does not turn over fast enough.


Total asset turnover

Measures the efficiency of resource use, i.e., the ability to generate sales through the use of assets. This ratio can be significantly affected by the depreciation method used by the company, as well as the age of assets

All-Things has been steadily improving and is slightly above the industry average.


Inventory turnover

Measures how quickly inventory is sold as well as how effectively investment in inventory is used and managed. This ratio can be significantly affected by the inventory costing method used.

All-Things' ratio has been steadily declining and is below the industry average. This slower than average situation may indicate a decline in operating efficiency, hidden obsolete inventory, or overpriced stock items.


Times interest earned

Measures the ability to meet interest commitments from current earnings. The higher the ratio, the more safety there is for long-term creditors.

All-Things' ratio has been improving over the last three years and is above the industry average. This indicates that All-Things has been paying down or refinancing debt, or increasing sales and profits, which is a sign of long-term stability.


Total debt to net worth

Measures the level of protection creditors have in the case of possible insolvency. Measures the degree of financial leverage and whether or not the firm will be able to obtain additional financing through borrowing.

All Things' ratio has deteriorated slightly in Year 6, but has been below the industry average over the last three years. This indicates that All-Things should be able to raise additional financing through debt and still remain below the industry average, indicating long-term stability.


Net profit margin

Measures the net income generated by each dollar of sales. The net profit margin ratio provides some indication of the ability of the firm to absorb cost increases or sales declines.

All-Things' net profit margin has been improving and is currently above the industry average. Furthermore, this improving net profit margin indicates the ability of the firm to weather soft economic periods, pay down debt, or take on additional debt for expansion.




At least two limitations of ratio analysis include the following.

It is often difficult to make comparisons among firms within an industry due to accounting differences. Different numbers can be shown in the financial statements for the same economic event because of different accounting methods, such as straight-line depreciation versus accelerated methods, LIFO versus FIFO inventory valuations. etc.

Ratios represent conditions that existed in the past, and may not be an indication of the future trend.





192,000 Dr. = 700,000 - 500,000 - 8,000


6,000 Cr. = (.02 700,000) - 8,000


19,000 = 10,000 + 9,000


16,000 = 6,000 + 10,000


676,000 = 192,000 + 800,000 - 16,000 - 300,000


291,000 = 300,000 - 9,000








Year 7

Year 8


Sales revenue




Cost of goods sold




Gross profit

$ 960,000 



Other expenses




Net income before taxes

$ 720,000 

$ 720,000 


Income tax expense




Net income

$ 504,000 

$ 504,000 







Year 7

Year 8


Sales revenue-Year 7


$ 480,000 


Sales revenue-Year 8




Cost of goods sold-Year 7

$ (972,000)

$ (288,000)


Cost of goods sold-Year 8




Gross profit

$ 648,000 

$ 926,400 


Other expenses




Taxable income

$ 408,000 

$ 566,400 





An earthquake would be considered a nonrecurring item peripheral to primary operating activities. The sale of an operating division would be a nonrecurring item related to primary operating activities.


Companies separate these times for users so that they can evaluate ongoing, normal activities separately from activities that are not expected to reoccur.