Ratio Analysis

Basic Analytic Procedures

Horizontal analysis of the balance sheets and income statements is accomplished by computing the dollar amount, direction, and percentage of the change in each balance sheet or income statement account from one period[Page 481] to another or by comparing the changes of one or more periods to a selected base period. The data derived can be reviewed to determine if particularly favorable or unfavorable trends are indicated.

Vertical analysis of the balance sheet requires that the dollar amount of each asset account is expressed as a percentage of the total assets, and that the dollar amount of each liability and equity account is expressed as a percentage of the total of the liabilities and equity. After vertical analysis percentages are determined, a horizontal analysis of the data can be prepared for comparison with one or more preceding periods or with industry-wide trends.

Common-size statements reflect the horizontal analysis data or the vertical analysis data as percentages. Similar percentages are computed and then compared with those of competing businesses or industry averages in order to determine trends.

Solvency Analysis

The ability of a business to meet current and long-term financial obligations to creditors is of great interest to business owners, creditors, and investors. Some of the techniques, which can be useful to a medical practice, include the following:

Working capital is computed as the difference between total current (short-term) assets and total current (short-term) liabilities on the balance sheet. The dollar amount should be positive; however, if the working capital seems too large in comparison with industry averages, further examination of the individual current accounts is indicated.

The current ratio is determined by dividing the total current assets by the total current liabilities. If the current ratio is less than 1, current liabilities exceed current assets; a short-term solvency problem could exist with respect to meeting creditor claims. How large the current ratio should be is determined by many factors. As with working capital, if the current ratio is very large in comparison to industry averages, the business may need to reassess its capital structure.

The quick (or acid test) ratio is a more conservative variation of the current ratio. The quick ratio is computed as (cash + marketable securities + receivables), all divided by total current liabilities. A quick ratio of 1 or slightly higher generally indicates good short-term solvency or instant debt-paying ability.

The ratio of operating cash flows to current liabilities is computed by dividing cash flows from operations by the average current liabilities (the average current liabilities may be computed by adding the beginning and ending current liabilities and dividing the total by 2). As current liabilities are generally satisfied by paying out cash, the operating cash flows to current liabilities is a more conservative measure of solvency than the current and quick ratios, which include noncash current assets.

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