Audit Evidence: Analytical Procedures - Lesson 3 - YouTube

Okay, now what are some of the ratios that we're going to be concerned with?

And there are a variety of ratios that we look at.

Some of the ratios that you'll see.

There's the current ratio, quick ratio, inventory turnover ratio, receivable turnover, debt

to equity ratio and so on.

So some of the ratios of concern for us.

Current ratio.

Current ratio is current assets over current liabilities.

It tells us how solvent the company is.

If you've got four to one, that's good.

If you've got one to four, that ain't so good.

Then we've got what we call the quick or the acid test ratio and that's going to be these

assets that are quickly convertable to cash.

Of your current assets, which are quickly convertable?

How about cash?

How about marketable securities because a marketable security has a market.

I own 100 shares of Apple, could I sell it today?

Sure.

How about accounts receivable, net AR?

Well receivables, would someone buy your receivables?

Could you factor, pledge, discount receivables?

Yes you could, so they have a value.

Divided by current liabilities.

So what's missing from here to here?

Here, this includes inventory.

With inventory, can you quickly convert inventory?

No, because you may have inventory that obsolete.

You may have inventory that's overvalued.

It's not lower of cost or market and so on.

So therefore, that's not part of the quick or acid test.

We have what we call accounts receivable turnover ratio.

What is turnover?

Whenever you see the word turnover, take the name and turn it over.

So it's going to be something over average AR.

Hmm, okay, and now accounts receivable comes out of what?

Sales but what kind of sales?

Total sales?

No, because a total sale-- If somebody pays you cash what's the probability of collecting

it?

100 percent as long as it's not counterfeit fake money.

So it's going to be net credit sales.

So credit sales over average AR, that's going to give you some kind of ratio, let's say

6.0.

What does 6.0 mean?

It means that your receivables turnover six times a year or every two months.

That tell you valuation that maybe your receivables are so old that they're not going to be collectable.

So if you're going to buy-- Let's say you want to buy my company and I go hey, I've

got accounts receivable of one million dollars, I'll sell them to you for one million dollars.

You're going to say, wait a sec, how much are they really worth?

That's where you have to go out and you've got to figure out how often do they turnover.

If receivables turnover six times a year or every two months and I've got receivables

that are six months old, you're going to go, dude they should have zero value.

I'm not going to pay you face value for those, they're not worth it.

That's where you have to go through and we learn in financial accounting about an aging

of AR or basically so we're going through and we're aging zero to 30 day old, we're

going to assume two percent�s on collectable. 30 to 60 days old, five percent.

60 to 90 days old, 10 percent and so on.

So you're aging them to see what the real value should be, that's called average AR.

So that tells you how many times.

Another one is called inventory turnover.

Again, flip it something over average inventory.

How about costs of goods sold?

Now what does that tell you?

That tells you that-- Let's say its 6.0 that tells you inventory turns over six times a

year or every two months.

So I'm selling you my company or you�re evaluating my balance sheet and you go, hey,

inventory turns over six times a year or every two months, if you have inventory that's three

months old, maybe it's obsolete.

Maybe we need an inventory adjustment.

Maybe my inventory is milk and its six months old, it isn�t salable.

It's called buttermilk.

So the point is, we're going to have a lot of adjustment inventories overstated.

Again, get into the mindset.

The client wants to make themselves look bigger, better, stronger, healthy.

So what do they do?

Overstate assets, overstate receivables, overstate inventory.

Those receivables, they ain�t collectable.

Inventory, it ain't salable, right?

You can't sell it.

No one wants it.

So those are the purpose of ratio.

Debt to equity, total liabilities divided by total stock holders� equity.

Those are just some of the different ratios.

Now in your notes you'll see that we put a whole list of important ratios.

You will see these in some of the questions.

I don't want you to memorize them all but as you�re doing the homework, if they're

asking you about a particular ratio, go ahead and refer back to the table, back to the chart

so you can kind of work through it and see if the numbers make sense.

You'll see here, they're broken up between liquidity, which measures the company's short

term ability to pay its obligations.

Activity, measures how effectively the company uses its assets.

Profitability, measures the degree of success or failure of a given company or division

for a given period of time, profitability.

Coverage measures the degree of protection for long term creditors and investors.

Okay so, some of these-- Okay, working capital is what?

Current assets minus current liabilities.

So that is current assets minus current liabilities and here you'll see the purpose or use measures

the company's solvency.

How solvent am I?

My current assets minus current liabilities.

Current ratio, that's this one, current assets divided by current liabilities measures short

term debt paying ability.

So this is short term because it's current over current liabilities.

Quicker acid test, cash, marketable securities, receivables, divided by current liabilities

measures immediate short term liquidity.

So notice here, this one is more accurate than this because it includes everything that's

quickly convertible.

That's why it's called the quick or acid test.

Because it's all your current assets quickly convertible into cash.

Current cash debt, coverage ratio, net cash provided by operative activities over average

current liabilities, measures the company's ability to pay off its current liabilities

in a given year.