5.3 Apply the Results from the Adjusted Trial Balance to Compute Current Ratio and Working Capital Balance, and Explain How These Measures Represent Liquidity

Cash Basis versus Accrual Basis Accounting

There are several reasons accrual-basis accounting is preferred to cash-basis accounting. Accrual-basis accounting is required by US generally accepted accounting principles (GAAP), as it typically provides a better sense of the financial well-being of a company. Accrual-based accounting information allows management to analyze a company’s progress, and management can use that information to improve their business. Accrual accounting is also used to assist companies in securing financing, because banks will typically require a company to provide accrual-basis financial income statements. The Internal Revenue Service might also require businesses to report using accrual basis information when preparing tax returns. In addition, companies with inventory must use accrual-based accounting for income tax purposes, though there are exceptions to the general rule.

So why might a company use cash-basis accounting? Companies that do not sell stock publicly can use cash-basis instead of accrual-basis accounting for internal-management purposes and externally, as long as the Internal Revenue Service does not prevent them from doing so, and they have no other reasons such as agreements per a bank loan. Cash-basis accounting is a simpler accounting system to use than an accrual-basis accounting system when tracking real-time revenues and expenses.

Let’s take a look at one example illustrating why accrual-basis accounting might be preferred to cash-basis accounting.

In the current year, a company had the following transactions:

Remember, in a cash-basis system you will record the revenue when the money is received no matter when the service is performed. There was no money received from customers in January or February, so the company, under a cash-basis system, would not show any revenue in those months. In March they received the $2,500 customers owed from January sales, $2,400 from customers for February sales, and $1,800 from cash sales in March. This is a total of $6,700 cash received from customers in March. Since the cash was received in March, the cash-basis system would record revenue in March.

In accrual accounting, we record the revenue as it is earned. There was $2,500 worth of service performed in January, so that will show as revenue in January. The $2,400 earned in February is recorded in February, and the $2,450 earned in March is recorded as revenue in March. Remember, it does not matter whether or not the cash came in.

For expenses, the cash-basis system is going to record an expense the day the payment leaves company hands. In January, the company purchased an insurance policy. The insurance policy is for the entire year, but since the cash went to the insurance company in January, the company will record the entire amount as an expense in January. The company paid the December electric bill in January. Even though the electricity was used to earn revenue in December, the company will record it as an expense in January. Electricity used in January, February, and March to help earn revenue in those months will show no expense because the bill has not been paid. The company forgot to pay January’s rent in January, so no rent expense is recorded in January. However, in February there is $2,000 worth of rent expense because the company paid for the two months in February.

Under accrual accounting, expenses are recorded when they are incurred and not when paid. Electricity used in a month to help earn revenue is recorded as an expense in that month whether the bill is paid or not. The same is true for rent expense. Insurance expense is spread out over 12 months, and each month 1/12 of the total insurance cost is expensed. The comparison of cash-basis and accrual-basis income statements is presented in Figure 5.9.

Figure 5.9 Cash Basis versus Accrual Basis Accounting. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Compare the two sets of income statements. The cash-basis system looks as though no revenue was earned in the first two months, and expenses were excessive. Then in March it looks like the company earned a lot of revenue. How realistic is this picture? Now look at the accrual basis figures. Here you see a better picture of what really happened over the three months. Revenues and expenses stayed relatively even across periods.

This comparison can show the dangers of reporting in a cash-basis system. In a cash-basis system, the timing of cash flows can make the business look very profitable one month and not profitable the next. If your company was having a bad year and you do not want to report a loss, just do not pay the bills for the last month of the year and you can suddenly show a profit in a cash-basis system. In an accrual-basis system, it does not matter if you do not pay the bills, you still need to record the expenses and present an income statement that accurately portrays what is happening in your company. The accrual-basis system lends itself to more transparency and detail in reporting. This detail is carried over into what is known as a classified balance sheet.

The Classified Balance Sheet

A classified balance sheet presents information on your balance sheet in a more informative structure, where asset and liability categories are divided into smaller, more detailed sections. Classified balance sheets show more about the makeup of our assets and liabilities, allowing us to better analyze the current health of our company and make future strategic plans.

Assets can be categorized as current; property, plant, and equipment; long-term investments; intangibles; and, if necessary, other assets. As you learned in Introduction to Financial Statements, a current asset (also known as a short-term asset) is any asset that will be converted to cash, sold, or used up within one year, or one operating cycle, whichever is longer. An operating cycle is the amount of time it takes a company to use its cash to provide a product or service and collect payment from the customer (Figure 5.10). For a merchandising firm that sells inventory, an operating cycle is the time it takes for the firm to use its cash to purchase inventory, sell the inventory, and get its cash back from its customers.

Figure 5.10 Operating Cycle. (credit left: modification of “All Sales Final” by Dan Keck/Flickr, Public Domain; credit center: modification of “Money Wallet Finance” by “Goumbik”/Pixabay, CC0; credit right: modification of “Inventory for Seasonal Decoration” by Mirko Tobias Schäfer/Flickr, CC BY 2.0)

If an asset does not meet the requirements of a current asset, then it is classified as a long-term asset. It can be further defined as property, plant, and equipment; a long-term investment; or an intangible asset (Figure 5.11). Property, plant, and equipment are tangible assets (those that have a physical presence) held for more than one operating cycle or one year, whichever is longer. A long-term investment is stocks, bonds, or other types of investments that management intends to hold for more than one operating cycle or one year, whichever is longer. Intangible assets do not have a physical presence but give the company a long-term future benefit. Some examples include patents, copyrights, and trademarks.

Liabilities are classified as either current liabilities or long-term liabilities. Liabilities also use the one year, or one operating cycle, for the cut-off between current and noncurrent. As we first discussed in Introduction to Financial Statements, if the debt is due within one year or one operating cycle, whichever is longer, the liability is a current liability. If the debt is settled outside one year or one operating cycle, whichever is longer, the liability is a long-term liability.

Figure 5.11 Asset Classification Flowchart. A flowchart for asset classification can assist with financial reporting. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

As an example, the balance sheet in Figure 5.12 is classified.

Figure 5.12 Classified Balance Sheet for Magnificent Landscaping Service. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Using Classified Balance Sheets to Evaluate Liquidity

Categorizing assets and liabilities on a balance sheet helps a company evaluate its business. One way a company can evaluate its business is with financial statement ratios. We consider two measures of liquidity, working capital, and the current ratio. Let’s first explore this idea of liquidity.

We first described liquidity in Introduction to Financial Statements as the ability to convert assets into cash. Liquidity is a company's ability to convert assets into cash in order to meet short-term cash needs, so it is very important for a company to remain liquid. A critical piece of information to remember at this point is that most companies use the accrual accounting method to determine and maintain their accounting records. This fact means that even with a positive income position, as reflected by its income statement, a company can go bankrupt due to poor cash flow. It is also important to note that even if a company has a lot of cash, it may still be in bankruptcy trouble if all or much of that cash is borrowed. According to an article published in Money magazine, one in four small businesses fail because of cash flow issues.¹ They are making a profit and seem financially healthy but do not have cash when needed.

Companies should analyze liquidity constantly to avoid cash shortages that may result in a need for a short-term loan. Intermittently taking out a short-term loan is often expected, but a company cannot keep coming up short on cash every year if it is going to remain liquid. A seasonal business, such as a specialized holiday retailer, may require a short-term loan to continue its operations during slower revenue-generating periods. Companies will use numbers from their classified balance sheet to test for liquidity. They want to make sure they have enough current assets to pay their current liabilities. Only cash is used to directly pay liabilities, but other current assets, such as accounts receivable or short-term investments, might be sold for cash, converted to cash, or used to bring in cash to pay liabilities.

Two calculations a company might use to test for liquidity are working capital and the current ratio. Working capital, which was first described in Introduction to Financial Statements, is found by taking the difference between current assets and current liabilities.

A positive outcome means the company has enough current assets available to pay its current liabilities or current debts. A negative outcome means the company does not have enough current assets to cover its current liabilities and may have to arrange short-term financing. Though a positive working capital is preferred, a company needs to make sure that there is not too much of a difference between current assets and current liabilities. A company that has a high working capital might have too much money in current assets that could be used for other company investments. Things such as industry and size of a company will dictate what type of margin is best.

Let’s consider Printing Plus and its working capital (Figure 5.13).

Figure 5.13 Balance Sheet for Printing Plus. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Printing Plus’s current assets include cash, accounts receivable, interest receivable, and supplies. Their current liabilities include accounts payable, salaries payable, and unearned revenue. The following is the computation of working capital:

This means that you have more than enough working capital to pay the current liabilities your company has recorded. This figure may seem high, but remember that this is the company’s first month of operations and this much cash may need to be available for larger, long-term asset purchases. However, there is also the possibility that the company might choose to identify long-term financing options for the acquisition of expensive, long-term assets, assuming that it can qualify for the increased debt.

Notice that part of the current liability calculation is unearned revenue. If a company has a surplus of unearned revenue, it can sometimes get away with less working capital, as it will need less cash to pay its bills. However, the company must be careful, since the cash was recorded before providing the services or products associated with the unearned revenue. This relationship is why the unearned revenue was initially created, and there often will be necessary cash outflows associated with meeting the terms of the unearned revenue creation.

Companies with inventory will usually need a higher working capital than a service company, as inventory can tie up a large amount of a company’s cash with less cash available to pay its bills. Also, small companies will normally need a higher working capital than larger companies, because it is harder for smaller companies to get loans, and they usually pay a higher interest rate.

The current ratio (also known as the working capital ratio), which was first described in Introduction to Financial Statements, tells a company how many times over company current assets can cover current liabilities. It is found by dividing current assets by current liabilities and is calculated as follows:

For example, if a company has current assets of $20,000 and current liabilities of $10,000, its current ratio is $20,000/$10,000 = two times. This means the company has enough current assets to cover its current liabilities twice. Ideally, many companies would like to maintain a 1.5–2 times current assets over current liabilities ratio. However, depending on the company’s function or purpose, an optimal ratio could be lower or higher than the previous recommendation. For example, many utilities do not have large fluctuations in anticipated seasonal current ratios, so they might decide to maintain a current ratio of 1.25–1.5 times current assets over current liabilities ratio, while a high-tech startup might want to maintain a ratio of 2.5–3 times current assets over current liabilities ratio.

The current ratio for Printing Plus is $26,540/$5,400 = 4.91 times. That is a very high current ratio, but since the business was just started, having more cash might allow the company to make larger purchases while still paying its liabilities. However, this ratio might be a result of short-term conditions, so the company is advised to still plan on maintaining a ratio that is considered both rational and not too risky.

Using ratios for a single year does not provide a broad picture. A company will get much better information if it compares the working capital and current ratio numbers for several years so it can see increases, decreases, and where numbers remain fairly consistent. Companies can also benefit from comparing this financial data to that of other companies in the industry.