Engineering Economic Analysis

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The Balance Sheet 543

For Engineered Industries, there would be $4,670,000-$2,180,000= $2,490,000

available in working capital.

Equity

Equity is also calledowner's equityornet worth.It includes the par value of the owners'

stockholdings and the capital surplus,which are the excess dollars brought in overpar value

when the stock was issued. Retained earnings are dollars a firm chooses to retain rather than

paying out as dividends to stockholders.Equity is the dollar quantity that alwaysbrings the

balance sheet, and thus the fundamental accounting equation, into balance. For Engineered

Industries,total equityvalue is listed at $10,435,000. From Equation 18-1 and the assets,

liabilities, and equity values in Figure 18-2, we can write the balance as follows:

Assets=Liabilities + Equity

Assets(current, fixed, other) = Liabilities(current and long-term) + Equity

(4,670,000 + 4,485,000 + 560,000) = (2,180,000 + 1,200,000) + 10,435,000

$13,815,000 = $13,815,000

An example of owner's equity is ownership of a home. Most homes are purchased by

means of a mortgage loan that is paid off at a certain interest rate over 15 to 30 years. At

any point in time, the difference between what is owed to the bank (the remaining balance

on the mortgage) and what the house is worth (its appraised market value) is theowner's

equity.In this case, the loan balance is theliability,and the home's value is theasset-with

equitybeing the difference. Over time, as the house loan is paid off, the owner's equity

increases.

The balance sheet is a very useful tool that shows one view of the firm's financial

condition at a particular point in time.

Financial Ratios Derived from Balance Sheet Data

One common way to evaluate the firm's health is through ratios of quantities on the balance

. sheet. Firms in a particular industry will typically have similar values, and exceptions will
often indicate firms with better or worse performance. Two common ratios used to analyze
the firm's current position are the current ratio and the acid-test ratio.
A firm'scurrent ratiois the ratio of current assets to current liabilities, as in Equa-
tion 18-3.

Current Ratio=Current assets/Current liabilities (18-3)

This ratio provides insight into the firm's solvency over the short term by indicating its

ability to cover current liabilities. Historically, firms aim to be at or above a ratio of 2.0;

however, this depends heavily on the industry as well as the individual firm's management

practices and philosophies. The current ratio for Engineered Industries in Figure 18-2 is

above 2 (4,670,000/2,180,000 = 2.14).

Both working capital and the current ratio indicate the firm's ability to meet currently

maturing obligations. However, neither describes the type of assets owned. Theacid-test