One way a business can manage its books and viability in the near and long terms is to see how liquid its assets are. Businesses that have better cash positions are naturally geared toward sustaining continued success. One important reason for a business to measure and maintain healthy levels of liquidity is because it promotes better odds that a company will be able to satisfy its short-term debts. There are many ways business can accomplish this, and below are four common ways it can be done.
One of the few liquidity ratios is what’s known as the current ratio. It’s a way to determine how well a company can pay back its debts.
The current ratio is also known as the “working capital ratio,” showing how well a business can satisfy financial obligations that must be paid back within 12 months. Using an example is a good way to see how it works:
Let’s assume a company has the following assets, it would use the following ratio:
Current Ratio = Current Assets / Current Liabilities
Marketable Securities such as stocks, bonds or purchase agreements maturing in 12 months or less can be considered a current asset. Businesses may also consider cash, accounts receivable, prepaid expenses, office supplies and saleable inventory they have in stock as current assets.
Outstanding bills or accounts payable and short-term debt – within the next 12 months as described above – are considered current liabilities. Other expenses can be interest payable, income and payroll taxes payable, which can also be considered current liabilities.
If the current assets of a business are $250 million, and that is divided by current liabilities of $75 million, the Current Ratio would be 250 / 75, or 3.33
With a current ratio of 3.33, the company is in good financial health because it can pay off its debts easily.
The Acid-Test Ratio determines how capable a company is of paying off its short-term liabilities with assets easily convertible to cash.
Also known as the quick ratio, the formula is as follows:
Acid-Test Ratio = Current Assets – Inventories / Current Liabilities
Current assets consist of cash and similar assets (savings/checking accounts, deposits becoming liquid in three months or less), marketable securities and accounts receivable. From there, the summation is divided by the company’s current liabilities expected to be paid in 12 months.
The other way to calculate the acid-test ratio or quick ratio is as follows:
The first step is to look at the company’s current assets that can be liquidated within 12 months. Then inventory must be valued – that which is intended to be sold for purchase. From there, the inventory value is subtracted from the current assets. The resulting value is then divided by the business’ current liabilities.
The acid-test ratio is one way to determine a company’s ability to satisfy current liabilities without selling inventory or getting more lending. With the uncertainty and profitability of selling inventory, one can argue that it gives a better picture of a company’s financial fitness.
For example, if a company comes out with a ratio of 3, this means that a business has $3 for every $1 of liabilities. However, as a company’s quick ratio increases, it might show there’s too much money not being reinvested to increase the company’s efficiency and profitability. A higher quick ratio figure can also indicate that there are too many accounts receivable that are owed but uncollected by the company.
As the name implies, the cash ratio determines how financially able a company is to satisfy short-term liabilities with cash and cash equivalents.
Also referred to as the cash asset ratio, this tells how capable a business is of satisfying short-term debts, usually 12 months or less, with cash and cash equivalents only. This ratio is as follows:
Cash Ratio = Cash and Cash Equivalents / Current Liabilities
Examples of cash and cash equivalents include physical currency, minted coins and checks. Cash equivalents include money market accounts, Treasury bills and anything that can be converted into cash in almost real-time.
When it comes to current liabilities, accrued liabilities, short-term debts and accounts payable are examples that are due within one year.
From there, the ratio is as follows to determine a company’s cash asset ratio:
Cash and Cash Equivalents (Cash: $25,000 + Cash Equivalents: $100,000) / Liabilities (Accounts Payable: $30,000 + Short-term debt: $25,000)
$125,000 / $55,000 = 2.27
Based on this calculation, the company would be able to pay off 227 percent of present liabilities with its cash and/or cash equivalents. For creditors and investors evaluating a company, it can show the company has ample liquidity. Creditors are naturally more willing to lend to companies with more cash flow; and investors are interested to see how liquidity is being managed.
Operating Cash Flow Ratio
This ratio measures how efficiently a business can meet present liabilities from the cash flow of its core business operations. It tells a company the number of times over it can satisfy its liabilities based on the amount of cash it generated over a certain time-frame.
This ratio can also include accruals, giving a fair estimate of a business’ short-term liquidity. The formula to determine this ratio is as follows:
Operating Cash Flow Ratio = Cash Flow from Operations / Current Liabilities
The statement of cash flow is where the operation’s cash flow is found. It can also be calculated by determining a company’s net income, plus non-cash expenses, plus working capital changes.
Current liabilities are defined as financial obligations due within the next 12 months. Common ones are accrued liabilities, accounts payable and/or short-term debt.
Once the operating cash flow ratio is calculated, a company’s financial health can be determined. If the ratio is 1.5 or 2, for example, it means the company can cover 1.5 times or double its present liabilities. However, if the ratio is less than 1, then the amount of cash generated from operations is insufficient to satisfy short-term liabilities.
As part of a comprehensive accounting practice, businesses that run these ratio calculations will be able to identify where there’s too little or too much liquidity and reduce current and future financial peril.
Depreciation is an accounting process where the cost of an asset is accounted for and expensed over its useful life. It shows how the value of the asset decreases over time. Assets that can be depreciated include buildings, fixtures, production equipment, etc. For intangible assets, including many types of intellectual property, this process is called amortization. For commodities mined or harvested from the earth, such as lumber, crude oil or natural gas, this process is called depletion. Here are four common types of depreciation.
Straight Line Method
In order to determine depreciation using this method, the following formula is used:
Depreciation = (Asset cost – Salvage value) / Useful life
The salvage value is the asset’s remaining value after its useful life, and the remaining amount from the asset’s cost is depreciable. The depreciable amount is divided by the asset’s useful life that’s used for depreciation expensing.
Double Declining Balance Depreciation
In order to calculate this method of depreciation, the first step is to look at the asset cost. From there, its useful life must be established. Let’s assume an asset’s book value is $75,000, it has a useful life of 10 years and a salvage value of $8,050.
Depreciation = (100 percent / asset’s useful life) X 2
= (100 percent / 10) X 2 = 20 percent
Year 1 depreciation expense = $75,000 X 20 percent = $15,000
Year 2 depreciation expense = $60,000 ($75,000 – $15,000 from Year 1) X 20 percent = $12,000
When beginning the first year, the book value is used as a basis for the asset’s value. The ending book value, which is determined after subtracting depreciation, is the following year’s new book value that will be used to establish next year’s depreciation expense. After it’s repeated through its useful life, the salvage value is left.
Units of Production Depreciation Method
This type of depreciation method depreciates a business’ asset by the units it produces or how many hours the asset is to be run for production over its useful life.
Depreciation = (Number of items manufactured / useful life in measured units) X (asset cost – salvage value)
Let’s assume a supplement pill machine cost $50,000; it can produce 200 million vitamins over its lifetime; and it will have a salvage value of $2,500. This assumes it will produce 20 million vitamins in the first 12 months of operation.
(20 million / 200 million) = 10 percent X ($50,000 – $2,500) = $47,500
If the machine produces 10 percent of vitamins over its expected 200 million vitamin unit life, the resulting depreciation amount is $4,750. At the end of the first year the book value will be $45,250. Production amounts in future years will dictate how much may be depreciated.
Sum of the Years Digits Approach
Similar to other methods of depreciation, the Sum of the Years Digits (SYD) depreciation method is another type of depreciation that assigns the bulk of depreciation in the beginning years of an asset’s useful life. Looking at the formula is the best way to understand how it works.
Expensing Depreciation = (Asset’s remaining life / Sum of the years digits) X (Asset’s cost – salvage value)
If a machine that’s going to be used by a company to produce widgets costs $50,000, has a useful life of 16 years and a salvage value of $3,000, it would look as follows:
1. $50,000 – $3,000 = $47,000 Depreciation Base
2. With 16 years of useful life for the asset, the sum of the years would be: 1 + 2 + 3 + 4 + 5 +6 + 7 + 8 + 9 + 10 + 11 + 12 + 13 + 14 + 15 + 16 = 136. Using the machine referenced above during the first year would equal a Remaining Life of 16. Then, the Remaining Life of 16 years would be divided by the SYD of 136.
3. Using this example, for the first year of using the machine, the formula would be as follows:
16 years (remaining life) / 136 (SYD) = 0.11764. Then, 0.11764 X $47,000 (Depreciation Base) = $5,529.08
The next (or second) year’s depreciation expense would by 15 / 136 = 0.110294. Then, 0.110294 X $47,000 = $5,183.82
Each subsequent year the SYD would be divided by the remaining years until it’s exhausted and the salvage value should be met.
Depending on the type of business, the type of asset and the accounting approach, there are different ways to expense for property acquired during the course of business.
When it comes to evaluating a business, especially one that is publicly traded, determining its return on equity (ROE) is one way to see how it’s performing.
What is Return on Equity?
Return on equity is a ratio that gives investors insight into how effectively the company’s management team is taking care of the shareholders’ financial investments in the company. The greater the ROE percentage, the better the business’ management staff is at making income and creating growth from shareholders’ investments.
How ROE is Determined
In order to calculate ROE, a company’s net income is divided by shareholder equity. To arrive at net income, businesses account for the cost of doing business, which includes the cost of goods sold, sales, operating and general expenses, interest, tax payments, etc. and then subtracts these costs of doing business from all sales. Similarly, the free cash flow figure can be substituted in place of net income.
There are some caveats when it comes to calculating net income. It is determined prior to paying out dividends to common shareholders, but loan interest and preferred shareholder dividend obligations must be met before starting this calculation.
The other part of the equation is the shareholder equity or stockholders’ equity. One definition is to subtract existing liabilities from a business’ assets, and what remains is what owners of a corporation or its shareholders would be able to claim as their equity in the company. Whether it’s done year over year or quarter over quarter, traders and investors can see how well a company performs over different time periods.
Return on equity is also able to be determined if a business’ net income and equity are in the black. The net income is found on the income statement – the ledger of the company’s financial transactions. Shareholders’ equity is found on the balance sheet – which details the business’ assets and financial obligations.
Analyzing a Business’ ROE
Another consideration that industry experts recommend to determine if a company’s ROE is poor or excellent is to see how it compares to the S&P 500 Index’s performance. With the historical rate of return being 10 percent annually over the past decade, and if a ROE is lower than 10 percent, it can give a good indication as to a particular business’ performance. However, a particular company’s ROE also needs to be compared against the industry’s ROE to see if the company is outperforming its sector.
For example, according to Yahoo Finance!, the ROE on Microsoft’s stock is 42.80 percent. This means that the management team running Microsoft is returning just shy of 43 cents for every dollar in shareholders’ equity. Compared to its industry (Software System & Application) ROE of 13.47percent – as cited by New York University’s Stern School of Business – Microsoft has a much higher ROE compared to the industry average. This is just one metric to measure the company’s performance, but it is an important one.
While looking at a company’s return on equity is not the end all or be all, it’s a good start to determine a company’s present and future financial health.
When it comes to determining depreciation for Furniture, Fixtures and Equipment (FF&E), there are many considerations that exist for accountants and business owners.
Defining Furniture, Fixtures and Equipment
FF&E refers to expenses for business items that are not affixed to the building where that business operates. Real world examples of depreciable assets includes chairs, desks, phones, tables, cabinets, etc., which are used to perform business-related tasks, directly or indirectly. These types of items are associated with long-term use generally more than 12 months, according to the Internal Revenue Service.
Understanding How It Works
When it comes to accounting for the expense of the item, it can be depreciated equally and discreetly over its useful life. According to the IRS’ General Depreciation System (GDS), these office items such as safes, desks and files, are expected to have a seven-year life.
While there are different approaches to calculate depreciation, a common way to do so is through straight-line depreciation. This method is used by many organizations, including The Federal Reserve, and it works by starting with how much the item cost to acquire or its adjusted basis. From there, the item’s cost is reduced by the salvage value, or the asset’s value after its useful life. The resulting figure is divided by the number of months of the asset’s useful life. Once the asset has exhausted this amount of time, it remains on the books as its salvage value until it’s sold or removed from service.
Using the straight-line method, a company might find the monthly depreciation charge for a truck purchase like this. The company purchases a new truck for $40,000; assuming a 60-month useful life allowable by the IRS and a 20 percent salvage value, the formula would be as follows:
In addition to tangible property, some intangible property also can be depreciated under the right circumstances. Examples the IRS cites of this primarily intellectual property includes copyrights, patents and software. Conditions for depreciation of this type of intangible property include that it must be owned by the business owner, used within the business or for profit-related activities, have a useful life and can be used by the business for more than a year.
The IRS gives an example of an individual buying a patent for $5,100. Using the straight-line method, the IRS permits this type of non-section 197 intangible property to be depreciated under certain conditions. The owner then must reduce any salvage value from the non-section 197 intangible property’s adjusted basis and depreciate it over the patent’s useful life, prorating terms less than a year, if applicable.
Eligible Intangible Property Example
Assume the individual bought a patent in May to be used starting June 1 of the same year. The patent was bought for $5,100, has a 17-year useful life and won’t have any salvage value.
The first year of depreciation must be prorated for six months, since it will be used from June to December of the first year. Taking these circumstances and rules from the IRS, the first year’s depreciation available is $150. Each subsequent year, the 16 remaining will be $300 each.
While there are many intricacies for depreciation, understanding how it applies to each business’ operations will help give a fair assessment of an equipment’s value.
As the name implies, First-In, First-Out (FIFO) is a way for companies to value their inventory. The first items put into inventory or produced by the company are accordingly the first taken out of inventory or transferred to customers and therefore expensed. When it comes to accounting for acquisition and/or production costs, initial and earlier costs are the first to be expensed, with more recent costs staying on the balance sheet to be expensed later.
Assume a company already has 200 widgets costing $4/widget. From there, the company increased its inventory at three more times during a selected accounting period. Three hypothetical, additional purchases include:
200 widgets @ $6/widget
200 widgets @ $7/widget
200 widgets @ $8/widget
If the company had 500 widgets purchased, there would be different considerations be it FIFO or LIFO. First, we’ll discuss FIFO.
For the 500 widgets sold to customers, the FIFO’s Cost of Goods Sold (COGS) (assuming there are no additional inputs that would increase the COGS for simplicity sake) would be $2,700.
This calculation will look at how COGS works for FIFO:
200 initial widgets costing $4/widget = $800 in COGS
200 widgets from the first additional purchase, costing $6/widget = $1,200 in COGS
100 widgets from the second additional purchase, costing $7/widget = $700 in COGS
For a total of $2,700 in COGS
Assuming there were no purchases during the selected accounting period, there would be 300 widgets remaining in inventory, or $3,000 in inventory costs. The inventory would show up on the balance sheet, according to the following calculation:
200 widgets @ $7/widget = $1,400 in inventory
200 widgets @ $8/widget = $1,600 in inventory
Now this is compared to LIFO, or Last-In, First-Out, which accounts for expenses by looking at most recent costs first. With the same company selling the same 500 widgets in the same accounting time-frame, but expensing their most recent 500 widgets first, here is the rundown:
200 widgets @ $8/widget = $1,600 in COGS
200 widgets @ $7/widget = $1,400 in COGS
100 widgets @ $6/widget = $600 in COGS
For a total of $3,600 expensed
The inventory would be left as the following:
100 widgets @ $6/widget = $600
200 widgets @ $4/widget = $800
For a total of $1,400 in remaining inventory.
Considerations Between LIFO and FIFO
One important consideration when choosing between LIFO or FIFO is that more likely than not input costs rise over time. Therefore, valuations can change based on the type of method.
Looking at the LIFO method, taking out inventory that’s been produced most recently does not always reflect market prices of the remaining inventory, especially if remaining stock is a few years old. Along with Costs of Goods Sold lowering net income, if older inventory is obsolete and it can’t be sold, it’ll render the inventory’s value far below market prices.
When it comes to the FIFO method, you get a better indication of the remaining inventory’s value. However, using this method increases a business’ net income since remaining inventory can be older and is valued by the Cost of Goods Sold. Similarly, if net income increases, there’s also a good chance of greater tax obligations for the company.
These scenarios account for rising prices. However, if prices are falling, then these scenarios would be reversed.
With more than 1.4 million accounting jobs in 2018, according to the Bureau of Labor Statistics, there are many different uses for accountants and their skills. With the need for accuracy and transparency in private and public accounting, one important concept to explore is absorption, or full costing.
Absorption or full costing is an accounting method that is used by businesses to determine the complete cost of producing products or services.
When it comes to calculating the full cost, there are three main categories taken in account:
It’s important to note that with absorption or full costing, regardless of the accounting period, both variable and fixed selling and administrative costs are not included when calculating cost per item. These costs are accounted for in the accounting time, whenever the expenses actually occurred or on an accrual basis.
Along with being GAAP-compliant (following Generally Accepting Accounting Principles) when it comes to absorption or full costing, the direct material costs, labor costs and variable and fixed overhead expenses are factored into the per-product cost to the point of sale. Once sold, the expenses will then be reflected on the Income Statement within the COGS fields (Costs of Good Sold).
Further Considerations and Differences with Variable Costing
The primary difference between full costing and variable costing can be seen when it comes to fixed overhead manufacturing costs.
For the absorption or full costing approach, fixed manufacturing overhead costs are recognized when the product is sold. With the variable costing method, the fixed manufacturing overhead costs are accounted for when the business incurs the expenses for that product (i.e., during production time).
Whether or not produced items are sold or still part of the business’ inventory, the absorption costing approach assigns all expenses to the inventory. This helps companies calculate their net profit more precisely. The approach to determining net profit is especially helpful if a company’s inventory is unsold after the accounting timeframe when production occurred.
When fixed costs such as insurance, salary, advertising and related expenses add up quickly and to great amounts, this is something to keep in mind when determining private performance and public perception for publicly traded companies.
When it comes to an employer’s responsibility for non-exempt workers, according to the U.S. Department of Labor, there are many requirements businesses must follow related to payroll. In one example, there are strict regulations on what information employers must document for each non-exempt worker. While there’s no requirement on how the information is recorded, there are three main categories.
Personal details: This should include the employee’s name, complete address, Social Security number, date of birth and gender.
Job details: This must include the worker’s job description and hours clocked in each day and week.
Pay details: The employee’s hourly wage based on straight time, and how employees are compensated – be it hourly, weekly, project or item-based. It should include the number of hours worked each week, per day or per week non-overtime earnings, overtime earnings per work week, and the compensation paid to employee for the pay period. Also included should be the day of the employee’s check, for what time period worked is described, and all deductions or increases to the worker’s wages.
Depending on the type of record, employers have different time requirements for record archival. Payroll records must be maintained for 36 months. Schedules, timecards and deduction records for employee earnings must be held for 24 months and be readily accessible for inspection by the U.S. Department of Labor.
When there is minimal deviation from an employee’s schedule, employers simply have to confirm the employee adhered to the schedule. When there is a large deviation (working fewer or more hours than normally scheduled), the actual number of hours worked should be noted. It doesn’t matter how time is kept for an employee, as long as it’s kept – be it manually written by the worker, a supervisor or HR rep or with a time clock.
The IRS explains that employers are required to complete Form W-2 to maintain compliance with tip and wage payments. This should be completed and submitted by the end of the calendar year.
Employees who fill out the Form W-4 can mitigate estimated tax liability by specifying how much to have withheld from their compensation by their employer. An employee can claim exemption from federal income tax withholding if she had no income tax liability the prior year and does not expect to pay taxes in the coming year. However, the employer is still required to deduct the FICA tax for that employee.
Also known as the Federal Insurance Contributions Act (FICA), employers are required to withhold two different types of taxes: Social Security and Medicare. According to the Internal Revenue Service (IRS), employers are responsible to calculate and remit these taxes based upon each employee’s wages.
For the 2019 tax year, Social Security taxes for employer and employee are both 6.2 percent, or 12.4 percent total. This tax is limited to the first $132,900 in wages. The Medicare withholding rate is 1.45 percent of wages for both employer and employee, totaling 2.9 percent. Unlike Social Security taxes, for Medicare there’s no cap on the employee’s total salary. Additionally, for wages exceeding $200,000 for 2019, only the employee is taxed an additional 0.9 percent, in addition to the 1.45 percent (for a total of 2.35 percent of any wages exceeding $200,000 for the 2019 calendar tax year) for Medicare taxes.
Individual Estimated Taxes
Estimated Taxes are meant to satisfy many forms of taxes, and not just income tax obligations. It also includes the alternative minimum tax (AMT) and self-employment taxes. Whether it’s a single entrepreneur, a business partner or someone with equity in an S corporation, as long as they have $1,000 or greater in tax obligations, they have to pay estimated taxes, generally on a quarterly basis. When it comes to corporations, the threshold for estimated tax payments is $500 when they prepare their taxes. In additional to taxpayers under the tax liabilities outlined above, estimated taxes are not required for individuals who meet the following: there was no tax owed for the preceding year, the individual was a U.S. citizen or resident for the entire year, and the last tax year was for 12 months. Also note that self-employed workers must pay both the employer and employee portion of the FICA tax.
Much like the evolving landscaping of the U.S. Tax Code, the world of payroll is also subject to ongoing changes that are imperative to maintaining compliance.