Chapter 12, Problem 12.7E

1 (a)

To determine

Receivables turnover ratio

Explanation of Solution

Receivables turnover ratio: Receivables turnover ratio is mainly used to evaluate the collection process efficiency. It helps the company to know the number of times the accounts receivable is collected in a particular time period. This ratio is determined by dividing credit sales and sales return.

$\text{Receivables turnover ratio}=\frac{\text{Net credit sales}}{\text{Average accounts receivables}}$

Determine receivables turnover ratio.

$\begin{array}{c}\text{Receivables turnover ratio}=\frac{\text{Net credit sales}}{\text{Average accounts receivables}}\\ =\frac{\$1890,000}{\text{\$100,000 }\left(1\right)}\\ =18.9\text{ times}\end{array}$

Working Notes:

Determine the amount of average accounts receivables.

$\begin{array}{c}\begin{array}{l}\text{Average accounts}\\ \text{receivables}\end{array}\}=\frac{\left(\begin{array}{l}\text{Opening acounts }\\ \text{receivables}\end{array}\right)+\left(\begin{array}{l}\text{Closing acounts }\\ \text{receivables}\end{array}\right)}{\text{2}}\\ =\frac{\text{\$102,000}+\text{\$98,000}}{2}\\ =\frac{\text{\$200,000}}{2}\\ =\text{\$100,000}\end{array}$ (1)

1 (b)

To determine

Inventory turnover ratio

Explanation of Solution

Inventory Turnover Ratio:

This ratio is a financial metric used by a company to quantify the number of times inventory is used or sold during the accounting period.  

$\text{Inventory turnover ratio}=\frac{\text{Cost of goods sold}}{\text{Average inventory}}$

Determine receivables turnover ratio.

$\begin{array}{c}\text{Inventory turnover ratio}=\frac{\text{Cost of goods sold}}{\text{Average inventory}}\\ =\frac{\$1,394,250}{\text{\$97,500 }\left(2\right)}\\ =14.3\text{ times}\end{array}$

Working Notes:

Determine the amount of average accounts receivables.

$\begin{array}{c}\text{Average inventory}=\frac{\text{Opening inventory}+\text{Closing inventory}}{\text{2}}\\ =\frac{\text{\$90,000}+\text{\$105,000}}{2}\\ =\$97,500\\ \end{array}$ (2)

1 (c)

To determine

Current ratio

Explanation of Solution

Current Ratio:

Current ratio is used to determine the relationship between current assets and current liabilities. Current ratio is determined by dividing current assets and current liabilities. The ideal current ratio is 2:1

$\text{Current ratio}=\frac{\text{Current assets}}{\text{Current}\text{liabilities}}$

Determine current ratio.

$\begin{array}{l}\text{Current ratio}=\frac{\text{Current assets}}{\text{Current liabilities}}\\ =\frac{\$450,000\left(3\right)}{\$125,000\left(4\right)}\\ =3.6:1\end{array}$

Current assets and current liabilities are determined as follows:

$\begin{array}{c}\text{Current assets}=\text{Cash}+\text{Accounts receivable}+\text{Inventory}+\text{Other current assets}\\ =\$242,000+\$98,000+\$105,000+\$5000\\ =\$450,000\end{array}$ (3)

$\begin{array}{c}\text{Current liabilities}=\text{Accounts payable}+\text{Interest payable}+\text{Income tax payable}\\ =\$109,000+\$7000+\$9,000\\ =\$125,000\end{array}$ (4)

1 (d)

To determine

Acid-test ratio

Explanation of Solution

Acid-Test Ratio:

This ratio denotes that this ratio is a more rigorous test of solvency than the current ratio. It is determined by dividing quick assets and current liabilities. The acceptable acid-test ratio is 0.90 to 1.00. Use the following formula to determine the acid-test ratio:

$\text{Acid Ratio}=\frac{\text{Quick assets}}{\text{Current}\text{liabilities}}$

Determine acid-test ratio.

$\begin{array}{c}\text{Acid Ratio}=\frac{\text{Quick assets}}{\text{Current liabilities}}\\ =\frac{\text{\$345,000}\left(5\right)}{\$125,000\left(4\right)}\\ =2.8:1\end{array}$

Quick assets are determined as follows:

$\begin{array}{c}\text{Quick assets = Cash +Accounts receivable+Investments}\\ =\$322,362+\$45,000+\$5000\\ =\$345,000\end{array}$ (5)

1 (e)

To determine

Debt-equity ratio

Explanation of Solution

Debt-equity Ratio:

The debt equity ratio measures the relationship between the capital contributed by creditors and the capital contributed by the stockholders or owners. It indicates the long term solvency position of the company.

$\text{Debt equity Ratio}=\frac{\text{Total liabilities}}{\text{Stockholders' equity}}$

Determine debt equity ratio.

$\begin{array}{c}\text{Debt equity Ratio}=\frac{\text{Total liabilities}}{\text{Stockholders' equity}}\\ =\frac{\text{\$235,000}\left(6\right)}{\text{\$1,157,000}\left(7\right)}\\ =\text{ 20}\text{.3}\%\end{array}$

Total liabilities and stockholders’ equity are determined as follows:

$\begin{array}{c}\text{Total liabilities}=\left(\begin{array}{l}\text{Accounts payable}+\text{Interest}\\ \text{ payable}+\text{Income tax payable}\end{array}\right)+\left(\text{Notes Payable}\left(\begin{array}{l}\text{Long term }\\ \text{liabilities}\end{array}\right)\right)\\ =\left(\$109,000+\$7,000+\$9,000\right)+\$110,000\\ =\$235,000\end{array}$ (6)

$\begin{array}{c}\text{Stockholders' equity}=\left(\begin{array}{l}\text{Common stock}+\\ +\text{Retained earnings}\end{array}\right)\\ =\left(\$800,000+\$375,000\right)\\ =\$1,157,000\end{array}$ (7)

2)

To determine

To compare: Weather on company can have higher return on assets while the other has a higher return on equity

Explanation of Solution

Yes, one company can have higher current ratio because of higher prepaid expenses and Inventory comparing to other current asset. Inventory and prepaid expenses are less liquid and they are excluded in the calculation of acid-test ratio

Acid-test ratio will be always lower than the current ratio for the same company since the current ratio comprises of all current assets, while only cash, current investments and Accounts receivables are included in acid-test ration.