Chapter 13, Problem 13.4AP

1.

To determine

Compute the turnover, liquidity, and solvency ratios for the current year of Company T.

Answer to Problem 13.4AP

Turnover, liquidity, and solvency ratios for the current year of Company T are as follows:

Ratios or percentages	Result
Turnover Ratios
Total asset turnover	0.55
Fixed asset turnover	1.10
Receivable turnover ratio	1.59
Inventory turnover ratio	1.65
Liquidity Ratios
Current ratio	2.59
Quick ratio	2.01
Cash ratio	1.15
Solvency Ratios
Debt-to-equity ratio	0.67
Cash coverage ratio	3.84
Times interest earned ratio	5.50

Table (1)

Explanation of Solution

Turnover ratios: Following are the types of turnover ratios:

• Total Asset turnover: Total asset turnover is a ratio that measures the productive capacity of the total assets to generate the sales revenue for the company. Thus, it shows the relationship between the net sales and the average total assets.
• Fixed Asset turnover: Fixed asset turnover is a ratio that measures the productive capacity of the fixed assets to generate the sales revenue for the company. Thus, it shows the relationship between the net sales and the average total fixed assets.
• 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.
• 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.

Liquidity Ratios: Liquidity explains the extent of cash’s nearness to assets and liabilities. It explains how easily assets can be converted into cash. Following are the types of ratios that help to find liquidity position of a company.

• Current ratio: Current ratio is one of the liquidity ratios, which measures the capacity of the company to meet its short-term obligations using its current assets.
• Quick ratio: It is a ratio used to determine a company’s ability to pay back its current liabilities by liquid assets. Liquid assets such as cash and cash equivalents, marketable securities and net account receivables.
• Cash ratio: This ratio is used to measure the adequacy of the cash in the business. It is determined by dividing cash equivalents and current liabilities.

Solvency ratio: Solvency ratio measures the capacity of a company to sustain over a long period of time. Solvency ratios are debt to assets ratio, time interest earned ratio, and debt to equity ratio, and more.

• Debt-equity ratio: The debt-to-equity ratio indicates that the company’s debt as a proportion of its stockholders’ equity.
• Cash coverage ratio: This ratio indicates the relationship between the cash flows from operating activities and the interest payments.
• Times interest earned ratio: Times interest earned ratio quantifies the number of times the earnings before interest and taxes can pay the interest expense. First, determine the sum of income before income tax and interest expense. Then, divide the sum by interest expense.

Determine the ratios of Company T as given below:

Ratios or percentages	Formula	Calculation	Result
Turnover Ratios
Total asset turnover	$\frac{\text{Net Sales Revenue}}{\text{Average total assets}}$	$\frac{\text{\$110,000}}{\$199,750\left(1\right)}$	0.55
Fixed asset turnover	$\frac{\text{Net Sales Revenue}}{\text{Average net fixed assets}}$	$\frac{\text{\$110,000}}{\$100,000\left(2\right)}$	1.10
Receivable turnover ratio	$\frac{\text{Net credit sales }}{\text{Average net receivables}}$	$\frac{\text{\$55,000}\left(3\right)}{\$34,500\left(4\right)}$	1.59
Inventory turnover ratio	$\frac{\text{Cost of goods sold}}{\text{Average inventory}}$	$\frac{\text{\$52,000}}{\$31,500\left(5\right)}$	1.65
Liquidity Ratios
Current ratio	$\frac{\text{Current assets}}{\text{Current liabilities}}$	$\frac{\text{\$111,500}\left(6\right)}{\text{\$43,000}\left(7\right)}$	2.59
Quick ratio	$\frac{\left(\begin{array}{l}\text{Cash and }\\ \text{equivalents}\end{array}\right)+\left(\begin{array}{l}\text{Accounts }\\ \text{receivable}\end{array}\right)}{\text{Current liabilities}}$	$\frac{\text{\$86,500}\left(8\right)}{\text{\$43,000}\left(7\right)}$	2.01
Cash ratio	$\frac{\text{Cash and Cash Equivalents}}{\text{Current liabilities}}$	$\frac{\text{\$49,500}}{\text{\$43,000}\left(7\right)}$	1.15
Solvency Ratios
Debt-to-equity ratio	$\frac{\text{Total liabilities}}{\text{Total stockholders' equity}}$	$\frac{\text{\$83,000}\left(9\right)}{\text{\$123,500}\left(10\right)}$	0.67
Cash coverage ratio	$\begin{array}{l}\text{Cash }\\ \text{coverage ratio }\end{array}\}\text{=}\frac{\left(\begin{array}{l}\text{Cash flows from }\\ \text{operating activities }\end{array}\right)}{\text{Interest paid}}$	$\frac{\text{\$14,600}\left(\text{Given}\right)}{\text{\$3,800}\left(\text{Given}\right)}$	3.84
Times interest earned ratio	$\frac{\text{Net income}+\text{Interest expense}+\text{Tax expense}}{\text{Interest expense}}$	$\frac{\text{\$12,600}+\$4,000+\$5,400}{\text{\$4,000}\left(\text{Given}\right)}$	5.50

Table (2)

Working Note:

Determine the amount of average total assets:

$\begin{array}{c}\text{Average total assets}=\frac{\left(\text{Ending total assets}\right)+\left(\text{Beginning total assets}\right)}{2}\\ =\frac{\$206,500+\$193,000}{2}\\ =\frac{\$399,500}{2}\\ =\$199,750\end{array}$ (1)

Determine the amount of average net fixed assets.

$\begin{array}{c}\text{Average net fixed assets}=\frac{\left(\begin{array}{l}\text{Ending net }\\ \text{fixed assets}\end{array}\right)+\left(\begin{array}{l}\text{Beginning net }\\ \text{fixed assets}\end{array}\right)}{2}\\ =\frac{\$95,000+\$105,000}{2}\\ =\frac{\$200,000}{2}\\ =\$100,000\end{array}$ (2)

Determine the amount of net credit sales.

$\begin{array}{c}\text{Net credit sales}=\text{Total sales revenue}\times \frac{1}{2}(\text{Given})\\ =\$110,000\times \frac{1}{2}\\ =\$55,000\end{array}$ (3)

Determine the amount of average net receivables.

$\begin{array}{c}\text{Average net receivables}=\frac{\left(\begin{array}{l}\text{Ending accounts }\\ \text{receivable}\end{array}\right)+\left(\begin{array}{l}\text{Beginning accounts }\\ \text{receivable}\end{array}\right)}{2}\\ =\frac{\$37,000+\$32,000}{2}\\ =\frac{\$69,000}{2}\\ =\$34,500\end{array}$ (4)

Determine the amount of average inventory.

$\begin{array}{c}\text{Average net receivables}=\frac{\left(\text{Ending inventory}\right)+\left(\text{Beginning inventory}\right)}{2}\\ =\frac{\$25,000+\$38,000}{2}\\ =\frac{\$63,000}{2}\\ =\$31,500\end{array}$ (5)

Determine the amount of current assets.

$\begin{array}{c}\text{Current assets}=\text{Cash}+\left(\begin{array}{l}\text{Accounts }\\ \text{receivable}\end{array}\right)+\text{Inventories}\\ =\$49,500+\$37,000+\$25,000\\ =\$111,500\end{array}$ (6)

Determine the amount of current liabilities.

$\begin{array}{c}\text{Current liabilities}=\text{Accounts payable}+\text{Income taxes payable}\\ =\$42,000+\$1,000\\ =\$43,000\end{array}$ (7)

Determine the amount of quick assets.

$\begin{array}{c}\text{Quick assets}=\text{Cash}+\text{Accounts receivable}\\ =\$49,500+\$37,000\\ =\$86,500\end{array}$ (8)

Determine the amount of total liabilities.

$\begin{array}{c}\text{Total liabilities}=\left(\begin{array}{l}\text{Accounts}\\ \text{ payable}\end{array}\right)+\left(\begin{array}{l}\text{Income taxes}\\ \text{ payable}\end{array}\right)+\left(\begin{array}{l}\text{Note payable, }\\ \text{long-term}\end{array}\right)\\ =\$42,000+\$1,000+\$40,000\\ =\$83,000\end{array}$ (9)

Determine the amount of total stockholders’ equity.

$\begin{array}{c}\text{Total stckholders' equity}=\text{Capital stock}+\text{Retained earnings}\\ =\$90,000+\$33,500\\ =\$123,500\end{array}$ (10)

2.

To determine

To write: A comment on the turnover ratios for the current year of Company T.

Explanation of Solution

From Table (1), the results reveal that the average collection period and the average days to sell inventory is very long. Company T takes 229.56 days $\left(\frac{365\text{ days}}{1.59}\right)$ to collect its receivable and 221.21 days $\left(\frac{365\text{ days}}{1.65}\right)$ to sell its inventory. These ratios reveals that the Company T is very inefficient in managing receivables and maintaining inventory levels. The management of Company T needs to improve the inventory levels and the collection of receivables. The total asset turnover and fixed asset turnover ratio is quite satisfactory.