The current ratio: Balance sheet liquidity

The current ratio is a short term liquidity test to see if a company has the "cash" to pay its obligations. 

In book keeping the current ratio compares the current assets to the current liabilities of a company. The current ratio is one way lenders test your cash flow when they consider loaning you money. Lenders usually look for current ratios of 1.2 to 2, so any financial institution would consider this example’s current ratio of 2.36 to be a good sign. A current ratio under 1 is considered a danger sign because it indicates that the company doesn’t have enough cash to pay its current bills.

Example:

Current assets of $56000
/
Current Liabilities of $26000
= a current ratio of 2.1

Also known as "liquidity ratio", "cash asset ratio" and "cash ratio".

Current and Noncurrent Liabilities: The Balance Sheet Continued

International Accounting Standard 1: Presentation of Financial Statements or IAS 1 is an international financial reporting standard adopted by the International Accounting Standards Board (IASB) gives clear requirements on the classification of Liabilities.

IAS 1 paragraph 60 stipulates that an entity should present current and non-current liabilities as separate classifications in its statement of financial position, except when a presentation based on liquidity provides more relevant and reliable information. Whatever the method of presentation, an entity should disclose the amount expected to be settled after more than 12 months and less than 12 months.


Paragraph 69a–d of IAS 1 states that liabilities are to be classified as current if any one of four specified conditions is met. The conditions are:

a) It expects to settle the liability in its current operating cycle

b) It holds the liability primarily for trading

c) The liability is due to be settled within 12 months

d) It does not have an unconditional right to defer settlement of the liability for at least 12 months after the reporting period.

So in terms of classification of current liabilities on the balance sheet they are liabilities the company expects to settle within 12 months of the date on the balance sheet. Settlement comes either from the use of current assets such as cash on hand or from the current sale of inventory. Settlement can also come from swapping out one current liability for another.

Noncurrent or long-term liabilities are ones the company reckons aren’t going anywhere soon! In other words, the company doesn’t expect to be liquidating them within 12 months of the balance sheet date.

Examples of Current Liabilities include:

• Short term notes payable: Notes due in full less than 12 months after the balance sheet date are short term. For example, a business may need a brief influx of cash to pay mandatory expenses such as payroll. A good example would be a working capital loan, a loan to be paid back in the short term after revenue is earned. 
• Accounts payable: the account showing the amount payable to a companies lenders. 
• Dividends payable
• Current portion of long term notes payable: i.e. the loan amount due in the next 12 months. 

Examples of Noncurrent liabilities include:

• Long term leases
• Extended warranties on products
• Bonds payable: long term amounts due outside the normal 12 months. 

Understanding the balance sheet: The Basic Balance Sheet

All public companies and large proprietary companies are required by law to prepare a balance sheet as part of their formal annual financial report that complies with Australian Accounting Standards.

The balance sheet states a companies assets, liabilities and equity (net worth). It is also known as a "statement of financial position". Last weeks post discussed in detail the definitions of assets and liabilities.

The balance sheet provides a good picture of the financial health of a business and is a tool used to evaluate a business's liquidity. It helps a small business owner identify trends and quickly grasp the financial strength and capabilities of their business.How the Balance Sheet Works
The balance sheet is divided into two parts that, based on the following equation, must equal each other, or balance each other out. The main formula behind balance sheets is:

Assets = Liabilities + Shareholders\' Equity

This means that assets, or the means used to operate the company, are balanced by a company's financial obligations, along with the equity investment brought into the company and its retained earnings.

• Current assets:
  are items of value that are expected to be consumed or converted into cash within the next 12 months. Examples include cash, inventory that is turning over regularly and accounts receivable.
• Non-current assets:
  are not expected to be consumed or converted into cash within the next 12 months. Examples include assets that the business would generally keep for more than one year such as plant and equipment, cars and buildings.

Working Example:

Statement of Financial Position: AKA The Balance Sheet

A financial statement (or financial report) is a formal record of the financial activities of a business, person, or other entity. It contains a snap shot of the assets, liabilities and equity position of the entity at a particular point in time

In company law—a financial statement is often referred to as an account, although the term financial statement is also used, particularly by accountants.
For a business enterprise, all the relevant financial information, presented in a structured manner and in a form easy to understand, are called the financial statements. They typically include four basic financial statements, accompanied by amanagement discussion and analysis:

1. Statement of financial position: also referred to as a balance sheet, reports on a company's assets, liabilities, andownership equity at a given point in time.
2. Statement of comprehensive income: also referred to as a profit and loss statement (or a "P&L"), reports on a company's income, expenses, and profits over a period of time. A profit and loss statement provides information on the operation of the enterprise. These include sales and the various expenses incurred during the processing state.
3. Statement of changes in equity: explains the changes of the company's equity throughout the reporting period
4. Statement of cash flows: reports on a company's cash flow activities, particularly its operating, investing and financing activities.

Classification of assets and liabilities into significant groups in the  balance sheet is governed by the end uses of the financial statement. 

Assets: 

Items such as freehold premises, machinery (capital), Fixtures, Trademarks. Note assets may be tangible or intangible.

Australian Accounting Standards Board (AASB Framework, para. 49a) Defines assets as: A resource controlled by the entity as a result of past events & from which future economic benefits are expected to flow to the entity.

• Classified primarily according to degree of liquidity 
• Divided into current and non-current 

Liabilities: 

Future sacrifices of economic benefits that the entity is presently obliged to make to other entities as a result of past transactions or other past events. Examples include overdraft, bills payable, and debentures.

AASB Framework (para. 49b): A present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.

• Shown in order of repayment or maturity date 
• Divided into current and non-current

[Assets – Liabilities = Equity]

Owners Equity: 

The residual interest in the assets of the entity after deduction of its liabilities (AASB framework para. 49c)


• Residual interest in the Assets after deducting Liability

Major aspects of equity are:

1. That it ranks after payment of all other liabilities in the event of winding up.
2. It is not separately identifiable like other liabilities - net position of residual.

The Vertical Layout of a Balance Sheet

The Horizontal Layout of a Balance Sheet

Reserves, Bonus Shares, and Rights Issue

In financial accounting, the term reserve is most commonly used to describe any part of shareholders' equity, except for basic share capital. In nonprofit accounting, an "operating reserve" is commonly used to refer to unrestricted cash on hand available to sustain an organization, and nonprofit boards usually specify a target of maintaining several months of operating cash or a percentage of their annual income, called an Operating Reserve Ratio.

Features:

•Profits and gains made by the company that have not been distributed to shareholders
•Most common type of reserve is earned by the company that are held back for use within the company
•Other reserves may be created in certain circumstances - a reserve is created (asset revaluation reserve) when assets are re-valued at greater than their book value
•‘retained profits’ ,i.e. profits

Bonus issue of shares simply takes one form of shareholders’ equity (reserves) and transforms it into another form (share capital)

Bonus shares are additional shares a shareholder receives for an existing holding of shares in a company. If you dispose of bonus shares received on or after 20 September 1985, you may make a capital gain. You may also have to modify the cost base and the reduced cost base of your existing shares in the company if you receive bonus shares.


A rights issue is an issue of rights to buy additional securities in a company made to the company's existing security holders. When the rights are for equity securities, such asshares, in a public company, it is a way to raise capital under a seasoned equity offering. Rights issues are sometimes carried out as a shelf offering. With the issued rights, existing security-holders have the privilege to buy a specified number of new securities from the firm at a specified price within a specified time. 

In a public company, a rights issue is a form of public offering (different from most other types of public offering, where shares are issued to the general public).

Share Capital

Share capital or capital stock refers to the portion of a company's equity that has been obtained (or will be obtained) by trading stock to a shareholder for cash or an equivalent item of capital value. For example, a company can issue shares in exchange for computer servers, instead of purchasing the servers with cash.

For example, suppose ABC Inc. raised $2 billion from its initial public offering. Over the next year, the total value of its shares increases to $5 billion. In this case, the value of the share capital is still only $2 billion because ABC Inc. had received only $2 billion from the sale of its securities to the investing public.

•Dividends: transfers of assets made by a company to its shareholders
•Partly-paid shares: shares on which the full issue price has not been paid, but the balance is to be paid in a series of installments or ‘calls’
•Fully paid shares: shares on which the shareholders have paid the full issue price
•Preference shares: shares which have a fixed rate of dividend that must be paid before any ordinary share dividends can be paid. These have higher priority in the event of the company going in to liquidation

Corporate Governance and The Directors

Corporate governance refers to the system by which corporations are directed and controlled.

A board of directors is a body of elected or appointed members who jointly oversee the activities of a company or organization. Other names include board of governors, board of managers, board of regents, board of trustees, and board of visitors. It is often simply referred to as "the board".

The Australian Securities Exchange (ASX) Corporate Governance Council has developed Corporate Governance Principles for Australian listed entities. Companies listed on the ASX must comply with these Corporate Governance Principles on an ‘if not, why not’ basis. Although non-ASX listed companies are not required to comply with the ASX’s Corporate Governance Principles, they provide a useful framework for identifying those behaviours that are considered to be good corporate governance practices.

By Australian standards, a good corporate governance system would generally be expected to encompass the following characteristics:

• A formalisation of the functions reserved to the board and those delegated to management.
• A majority of the board would be independent directors. The chairperson would also be an independent director.
• The chairperson and the Chief Executive Officer would not be the same person.
• An established code of conduct for company officers.
• An established trading policy for company officers.
• An established audit committee.
• Established policies for the oversight and management of material business risks.
• An established remuneration policy for executives and non-executive directors.

Further details regarding corporate governance principles may be obtained from ASX’s website www.asxgroup.com.au.

The governance promotes disclosure, accountability and fairness. All large companies publish reports and have corporate govance schemes in place that adhere to these principals. 

•Public companies and ‘large’ proprietary companies must prepare annual financial reports - including financial statements and directors’ reports
•‘Small’ proprietary companies do not have these requirements unless requested by ASIC or by at least 5% of members
•To be ‘small’, they must satisfy at least 2 of:

Consolidated gross operating revenue < $25 million

Consolidated gross assets at end of year < $12.5 million

Must employ < 50 employees at end of year

	Public	Proprietary
Company name includes	‘Ltd’	‘Pty Ltd’
Public sale of shares	Yes	No
Typical size	Large	Smaller
Extent of regulation	Extensive	Moderate
Raise monies from public	Yes	Some restrictions
Subject to reporting requirements	Yes	Depends on size