Chapter 13, Problem 13.7E

To determine

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

Formula:

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

• Current cash debt coverage: It is a cash-basis measure of liquidity, which is determined by dividing the net cash provided by operating activities by average total current liabilities.

Formula:

$\text{Current cash debt coverage}=\frac{\text{Net cash provided by operating activities}}{\text{Average total current liabilities}}$

• Accounts receivable ratio:This 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. Main purpose of accounts receivable turnover ratio is to manage the working capital of the company.

Formula:

$\begin{array}{l}\text{Accounts receivables}\\ \text{ turnover ratio}\end{array}\}=\frac{\text{Net credit sales}}{\text{Average accounts receivables}}$

• Average collection period: Average collection period is used to determine the number of days a particular company takes to collect accounts receivables.

Formula:

$\text{Days' sales in receivables}=\frac{\text{Days in accounting period}}{\text{Accounts receivables turnover}}$

• Inventory turnover ratio: Inventory turnover ratio is used to determine the number of times inventory used or sold during the particular accounting period.

Formula:

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

• Days’ sales in inventory: Days’ sales in inventory are used to determine number of days a particular company takes to make sales of the inventory available with them.

  Formula:

$\text{Days' sales in inventory}=\frac{\text{Days in accounting period}}{\text{Inventory turnover}}$

To compute: Liquidity ratios