## Financial Accounting – Chapter 14 – Solvency & Profitability Analysis

Hello this is Connie Belden, and in this

video we’re gonna talk about solvency and profitability analysis. First of all

there is a summary of all of the formulas that you would use for solvency

and profitability analysis in this chapter, similar to what you see in front

of you, so I want to point out the first several of them working capital all the

way through number of times preferred dividends earned is referred to as

solvency analysis, it’s measuring the company’s ability to pay their debt.

Whereas the profitability analysis, from ratio of sales to assets through

dividend yield, goes beyond the ability to pay debt – it looks at the company’s

ability to make a profit. So let’s take a look at some of the commonly missed

analysis, it may look at first if they’re pretty straightforward because hey they

give you the formulas, however some of the formulas are a little trickier than

what you initially anticipated so I want to point out some of the more commonly

missed ones and then encourage you to take a look in detail at all of the

analysis in this chapter because they do show you how to work each one step by

step in this chapter. First one we want to point out is the quick ratio, the

quick ratio is also known as the acid test ratio, by the way and notice the

formula just says quick assets so you have to know what are your quick assets

in order to complete this formula and your quick assets by the way are gonna

be cash, accounts receivable, and any marketable securities, in other words

investments that are for the short term, so those three added together will be

your quick assets. Ikay I’m gonna look at a few of the

others that are on this handout that are commonly missed and kind of go over with

you how they are worked. The first one that’s commonly missed is a ratio of

sales to assets, the formula says take sales divided by average total assets

but notice that says excluding long-term

investments, and the trick about this one is you want to make sure that you

subtract the long term investments before you average the total assets. So

let’s assume from our financial statements we have sales of 40,000 and

in 2020 total assets were a hundred thousand and in 2021 total assets were

125. Now I want to average those two numbers but after I subtract out the

long-term investments. Let’s assume long-term investments for 5000 and 2020

and long-term investments for 10,000 in 2021, and again this would just be

long-term investments only not any short-term, okay so your top number is

gonna be sales 40,000 and your bottom number again is going to be the average

of the assets after you take out the long-term investments. Okay so what

you’re gonna do then is you’re going to take a hundred thousand minus five

thousand so that gives you ninety five thousand and then you’re gonna take 125

minus ten thousand so that gives you 115 thousand, so now you add the two numbers

together, your add 95 plus 115 and divide it by two, so 105 then is going to be

your bottom number. So again for ratio of sales to asset your take your sales

given a 40,000 divided by your average total assets after you took out the

long-term investments of 105 and that gives you 38.1%. Something I do want to

point out that anything referred to as a ratio will be expressed as a percentage.

Okay the second one rate earn uncommon stockholders equity, so the formula gives

you a net income minus preferred dividends for your top number, that part

is easy you can get the net income from the income statement, let’s assume it’s

30,000 and then if you go to the statement of retained earnings you can

get the amount that’s been paid out as common dividends and

preferred dividends, in this case we just want the preferred dividends and let’s assume

it was $2,000. Okay so our top number in a moment we’ll just be 30,000 – 2,000 for

28,000. You see 28,000 down here for my top number, now it’s the bottom number that’s tricky, it says average common stockholders

equity, so you may be tempted at first just to average the common stock, but it

says average common stockholders equity, that also has to include the retained

earnings, so what you have to do is add the common stock plus the retained

earnings for each year then you will average them. So for example let’s assume

the common stock in 2020 is a hundred thousand I will add it to the retained

earnings for 2020, so that gives me a hundred and twenty thousand, you see I

did that down here. For 2021 let’s assume that twenty thousand is for the one

hundred and ten thousand is for the common stock and twenty five thousand is

for the retained earnings so one hundred and ten thousand plus twenty five

thousand gives you one thirty five four 2021. So you see I added

the common stock for each year to its retained earnings for each year then I

added those two numbers together divided them by two, so my bottom number will be

127 five hundred, so twenty eight thousand divided by 127 five hundred

gives me twenty two percent, and again I suggest you go to the book it shows you

examples in detail showing you how to work each one but I wanted to go over in

this video my couple that I see that are commonly missed, so I hope that helps you

out, thank you very much.