Financial Accounting: In an Economic Context

REPORTING LIABILITIES ON THE BALANCE SHEET: ECONOMIC CONSEQUENCES

The reported values of liabilities affect important financial ratios that shareholders, investors, creditors, and others use to assess management's performance and a company's financial condition. Seven of Dun & Bradstreet's fourteen key business ratios, for example, directly include a measure of liabilities: (1) quick ratio ([cash + marketable securities + receivables]/current liabilities), (2) current ratio (current assets/current liabilities), (3) current liabilities/net worth, (4) current liabilities/ inventory, (5) total liabilities/net worth, (6) sales/net working capital, and (7) accounts payable/sales. These ratios and others that include liability measures are used by interested outside parties to determine credit ratings, assess solvency and future cash flows, predict bankruptcy, and, in general, assess the financial health of an enterprise. In addition to using liability measures to evaluate the future prospects of a firm, shareholders, investors, creditors, and managers are interested in the reported values of liabilities for other important reasons, several of which are discussed in the following paragraphs.

Shareholders and Investors

Debt financing can be very valuable to shareholders because funds generated by borrowing can be used to generate returns that exceed the cost of the debt. Since interest is tax deductible (reducing the cost of debt), this strategy (called leverage) is very common. However, ...