Chapter 12, Problem 7E

1. a

To determine

Calculate the receivables turnover ratio of Company P.

Explanation of Solution

Accounts receivable turnover:

This is the ratio which analyzes the number of times accounts receivables is collected and converted into cash during the period. This ratio gauges the efficacy of collecting receivables. Larger the ratio, more efficient in collecting receivables. This ratio is determined by dividing net credit sales and average accounts receivables.

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

Calculate the Receivables turnover ratio of Company P as follows:

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

Working Notes:

Ascertain 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)

Conclusion

Thus, the receivables turnover ratio of Company P is 18.9 times.

1. b

To determine

Calculate the inventory turnover ratio of Company P.

Explanation of Solution

Inventory turnover:

This is the ratio which analyzes the number of times inventory is sold during the period. This ratio gauges the efficacy of inventory management. Larger the ratio, more efficient the inventory management.

Formula:

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

Calculate the Inventory turnover ratio of Company P as follows:

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

Working Notes:

Ascertain 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)

Conclusion

Thus, the inventory turnover ratio of Company P is 14.3 times.

1. c

To determine

Calculate the current ratio of Company P.

Explanation of Solution

Current ratio:

The financial ratio which evaluates the ability of a company to pay off the debt obligations which mature within one year or within completion of operating cycle is referred to as current ratio. This ratio assesses the liquidity of a company.

Formula:

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

Calculate the Current ratio of Company P as follows:

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

Working Notes:

Calculate the value of current assets:

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

Calculate the value of current liabilities.

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

Conclusion

Thus, the current ratio of Company P is 3.6:1.

1. d

To determine

Calculate the acid-test ratio.

Explanation of Solution

Acid-test ratio:

The financial ratio which evaluates the ability of a company to pay off the instant debt obligations is referred to as quick ratio. Quick assets are cash, marketable securities, and accounts receivables. This ratio assesses the short-term liquidity of a company.

Formula:

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

Ascertain the acid-test ratio as follows:

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

Working Notes:

Ascertain the Quick assets:

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

Conclusion

Thus, the acid-test ratio of Company P is 2.8:1.

1. e

To determine

Calculate the debt-equity ratio.

Explanation of Solution

Debt-equity Ratio:

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

Formula:

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

Ascertain the debt equity ratio as follows:

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

Working Notes:

Ascertain the total liabilities and stockholders’ equity:

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

Conclusion

Thus, the debt equity ratio of Company P is 20.3%.

2.

To determine

Describe whether one company can have a higher return on assets, while the other company has a higher acid-test ratio, while comparing two companies.

Explanation of Solution

Yes, one company can have a higher current ratio, while the other has a higher acid-test ratio. Due to the higher prepaid expenses and prepaid inventory, the company could have a higher current ratio. When compared to the other current assets, only inventory and prepaid expenses are less liquid, and thus they are excluded in the calculation of acid-test ratio.

The acid-test ratio would always be lower than the current ratio for the same company, since the current ratio comprises all current assets, whereas in the acid-test ratio only cash, current investments and accounts receivables are included.