Completing the Accounting Cycle

This chapter will explain the steps required to complete the accounting cycle. This includes understanding the full accounting information cycle, and what is used to create the financial statements that will be provided to required and interested stakeholders. The accounting cycle happens every month for most companies, and requires distinct steps and cutoffs in order to create useful, consistent financial reports that managers can use to make decisions that improve the performance of the company. On a quartery and annual basis, financial statements are created for outside stakeholders as well.

Analyzing and using the financial results – the current ratio

The current ratio indicates the short-term debt-paying ability of a company. To find the current ratio, we divide current assets by current liabilities. For instance, Exhibit 26 shows that The Home Depot's current assets as of 2001 January 28, were USD 7,777,000,000 and its current liabilities were USD 4,385,000,000. Thus, its current ratio was: \text{Current ratio} =\frac{\text { Current assets }}{\text { Current liabilities }} \frac{\operatorname{USD} 7,777,000,000}{\operatorname{USD} 4,385,000,000}=1.77: 1.

The current ratio of 1.77:1 for The Home Depot means that it has almost twice as many current assets as current liabilities. Because current liabilities are normally paid with current assets, the company appears to be able to pay its short-term obligations easily.

In evaluating a company's short-term debt-paying ability, you should also examine the quality of the current assets. If they include large amounts of uncollectable accounts receivable and/or obsolete and unsalable inventory, even a 2:1 current ratio may be inadequate to allow the company to pay its current liabilities. The Home Depot undoubtedly does not have such a problem.

The current assets, current liabilities, and current ratios of some other companies as of the third quarter of 2001 were:

Current Company Current Assets Current Liabilities Ratio
Wal-Mart Stores, Inc. $ 32,620,000,000
$ 32,869,000,000 .99:1
Hewlett-Packard Company 15,782,000,000 13,950,000,000 1.13:1
3M Corporation 6,556,000,000 5,006,000,000 1.31:1
General Electric Company 313,050,000,000
168,788,000,000 1.85:1
Johnson & Johnson 19,079,000,000 7,504,000,000 2.54:1

We described each of these companies earlier in the text.

As you can see from these comparisons, the current ratios vary a great deal. An old rule of thumb is that the current ratio should be at least 2:1. However, what constitutes an adequate current ratio depends on available lines of credit, the cash-generating ability of the company, and the nature of the industry in which the company operates. For instance, companies in the airline industry are able to generate huge amounts of cash on a daily basis and may be able to pay their current liabilities even if their current ratio is less than 1:1. Comparing a company's current ratio with other companies in the same industry makes sense because all of these companies face about the same economic conditions. A company with the lowest current ratio in its industry may be unable to pay its short-term obligations on a timely basis, unless it can borrow funds from a bank on a line of credit. A company with the highest current ratio in its industry may have on hand too many current assets, such as cash and marketable securities, which could be invested in more productive assets.

The next chapter describes the assumptions, concepts, and principles that constitute the accounting theory underlying financial accounting. Thus, accounting theory dictates the standards and procedures applied to the reporting of financial information in the financial statements.