Thingamajigs and Things and Wannabees - Essay Example

Abstract
A ratio analysis is a tool used by employees to analyze a company’s financial statements (Investopedia, 2011). Ratios are calculated from the current year's numbers and then compared to other sources such as previous years, other companies, or the industry as a whole. This is an important tool for evaluating a firm’s credibility. There are many ratios that are used to determine a ratio analysis. These are short-term solvency ratios, debt management ratios, asset management ratios, profitability ratios, and market value ratios. The two ratios that make up short-term solvency ratios are the current ratio and the quick ratio or acid test ratio. The current ratio uses total current assets and total current liabilities. Total current assets are divided by total current liabilities to give the current ratio. Meanwhile, the acid test ratio is found by the use of total current assets, total current liabilities, and inventory. The equation for the quick ratio is inventory taken away from total current assets and divided by total current liabilities.
Keywords: Current ratio, acid test ratio, balance sheet, inventory, total current assets, total current liabilities.

Ratio Analysis
1. In order to work out the current ratio for Thingamajigs and Things, we first need to find out the components of the equation so we can calculate the current ratio. Thingamajigs and Things’ total current assets are worth $45,000, and their total current liabilities are $9,000. If we divide the total current assets by the total current liabilities then we get a ratio of exactly 5 (Lane, 2011). In looking at WannaBees, we can see that they have total current assets of $150,000 and total current liabilities of $85,000. Once we conduct the calculation for the current ratio, we get a figure of 1.76 (Lane, 2011). In determining what these numbers mean, we first have to judge what figure is an acceptable figure to have. The current ratio should not go below 1 or else the company should be concerned (Kennon, 2011). In general, a high current ratio shows that the business has sufficient amounts of cash on hand and cannot be considered a financial risk. In this case, Thingamajigs and Things have a much higher current ratio than WannaBees. If both of these companies were applying for a bank loan, Thingamajigs and Things would be more likely to receive it.
2. Thingamajigs and Things’ total current assets are $45,000, its total current liabilities are $9,000, and its inventory is worth $30,000. If we conduct an acid test ratio, we come up with a figure of 1.67 (Lane, 2011). On the other hand, WannaBees has total current assets of $150,000, total current liabilities of $85,000, and an inventory of $125,000. From this information, the quick ratio can be worked out as 0.29 (Lane, 2011). The acid test ratio gives a little more certainty about the performance of a firm than the current ratio does (Accounting Explanation, 2011). This is because inventory is added to the equation, and this is significant because inventory cannot be converted into cash easily. The best method to determine the financial health of a business is to use these two formulas side by side so a clearer picture can be seen. Most experts consider that the best ratio for the quick ratio test is 1. This means that a firm’s liquid assets are 100 percent of the current liabilities and this shows a good financial position. For this reason, I would not give WannaBees a bank loan as their quick ratio is under 1 (0.29). On the other hand, Thingamajigs and Things have an acid test ratio of over 1 (1.67). This means that Thingamajigs and Things would be more likely to pay back the loan because they are in a better financial position. Read More