Understanding Business Accounting For Dummies, 2nd Edition (48 page)

£8,555,000 current assets ÷ £4,080,000 current liabilities = 2.1 current ratio


The general rule is that a company's current ratio should be 1.5 or higher. However, business managers know that the current ratio depends a great deal on how the business's short-term operating assets are financed from current liabilities. Some businesses do quite well with a current ratio less than 1.5. Therefore, take the 1.5 current ratio rule with a grain of salt. A lower current ratio does not necessarily mean that the business won't be able to pay its short-term (current) liabilities on time. Chapters 14 and 17 explain current ratios in more detail.

Costs and Other Balance Sheet Values

The balance sheet summarises the financial condition for a business at a point in time. Business managers and investors should clearly understand the values reported in this primary financial statement. In our experience, understanding balance sheet values can be a source of confusion for both business managers and investors who tend to put all pound amounts on the same value basis. In their minds, a pound is a pound, whether it's in the debtors, stock, fixed assets, or accounts payable. Assigning the same value to every account value tends to gloss over some important differences and can lead to serious misinterpretation of the balance sheet.

A balance sheet mixes together several different types of accounting values:

Cash:
Amounts of money on hand in coin and currency; money on deposit in bank accounts

Debtors:
Amounts not yet collected from credit sales to customers

Stock:
Amounts of purchase costs or production costs for products that haven't sold yet

Fixed assets (or Property, plant, and equipment):
Amounts of costs invested in long-life, tangible, productive operating assets

Creditors
and
accrued liabilities:
Amounts for the costs of unpaid expenses

Overdrafts and loans:
Amounts borrowed on interest-bearing liabilities

Capital stock:
Amounts of capital invested in the business by owners (shareholders). This can be either by way of the initial capital introduced or profits left in the business after trading gets under way

Retained earnings (or reserves):
Amounts remaining in the owners' equity account

In short, a balance sheet represents a diversity, or a rainbow, of values - not just one colour. This is the nature of the generally accepted accounting principles (GAAP) - the accounting methods used to prepare financial statements.

Book values
are the amounts recorded in the accounting process and reported in financial statements. Do not assume that the book values reported in a balance sheet necessarily equal the current
market values.
Book values are based on the accounting methods used by a business. Generally speaking - and we really mean
generally
here because we're sure that you can find exceptions to this rule - cash, debtors, and liabilities are recorded at close to their market or settlement values. These receivables will be turned into cash (at the same amount recorded on the balance sheet) and liabilities will be paid off at the amounts reported in the balance sheet. It's the book values of stock and fixed assets that most likely are lower than current market values, as well as any other non-operating assets in which the business invested some time ago.