##### Accounting Workbook For Dummies

From the sales revenue and expenses reported in a business’s income statement, you can determine the balances of several assets and liabilities using the normative operating ratios for the business. Laying the foundation for the balance sheet of a business using its normative operating ratios is very instructive.

An operating ratio expresses the size of an asset or liability on the basis of sales revenue or an expense in the annual income statement. A normative operating ratio refers to how large an asset or liability should be relative to sales revenue or its related expense in the annual income statement.

Suppose a business, Company X, makes all its sales on credit and offers its customers one month to pay. Few customers pay early, and some customers are chronic late-payers. To encourage repeat sales, the business tolerates these late-payers, and as a result, its accounts receivable equals five weeks of annual sales revenue. Thus, its normative operating ratio of accounts receivable to annual sales revenue is 5 to 52.

The actual ratio of the year-end accounts receivable balance to annual sales revenue is unlikely to be precisely 5 to 52, which equals 9.615 percent of sales revenue. The 5 to 52 operating ratio is the normative ratio between accounts receivable and annual sales revenue; it’s based on the sales credit policies of the business and how aggressive the business is in collecting receivables when customers don’t pay on time. The 5 to 52 ratio is a benchmark, in other words.

The annual income statement of Company X is presented in the following figure. From the sales revenue and expenses reported in the income statement, you can determine the balances of several assets and liabilities using the normative operating ratios for the business.

Income statement of a business for the year just ended.

Operating ratios can be expressed in terms of weeks of the 52-week year (or they can be expressed as percentages of annual sales revenue or annual expense). This example uses weeks of the year. The normative operating ratios for the business whose income statement is presented in the figure are as follows:

• Cash equals 7 weeks of annual sales revenue.

• Accounts receivable equals 5 weeks of annual sales revenue.

• Inventory equals 13 weeks of annual cost of goods sold.

• The prepaid expenses asset balance equals 4 weeks of annual selling and general expenses.

• Accounts payable for inventory acquisitions equals 4 weeks of annual cost of goods sold.

• Accounts payable for supplies and services bought on credit equals 4 weeks of annual selling and general expenses.

• Accrued expenses payable for operating expenses equals 6 weeks of annual selling and general expenses.

The business doesn’t own intangible assets and therefore doesn’t have amortization expense. Accrued interest payable and income tax payable isn’t included in the example for two reasons:

• First, these year-end liabilities typically are relatively small amounts compared with the major assets and liabilities of a business.

• Second, the expenses that drive these liabilities aren’t operating expenses.

The year-end balance of accrued interest payable depends on the terms for paying interest on the business’s debt. Income tax expense, as you know, depends on the income tax status of the business and its policies regarding making installment payments toward its annual income tax during the year. In short, it’s not possible to apply operating ratios for these two liabilities.

The ratio of annual depreciation expense to the original cost of fixed assets can’t be normalized. Different fixed assets are depreciated over different estimated useful life spans. Some fixed assets are depreciated according to the straight-line method and others according to an accelerated depreciation method.

The annual depreciation expense should be a reasonable fraction of original cost. It would be unusual, and even suspicious, in fact, if depreciation expense were more than 15 percent or so of the total original cost of fixed assets.