Chapter 14, Problem 6AP

a.

To determine

Explain the reasons for reporting the interest expense in the income statement as $84,000 while the interest expense reported in the statement of cash flows is only $79,000.

Explanation of Solution

Net income: Net income is the excess amount of revenue after deducting all the expenses of a company. In simple terms, it is the difference between total revenue and total expenses of the company.

The statement of cash flows is prepared under the cash basis of accounting, whereas the income statement is prepared under accrual basis of accounting. Similarly, the interest expense of $79,000 that had been paid in cash is reported in the statement of cash flows and the interest expense of $84,000 that had incurred is reported in the income statement. The interest expense of $5,000$\left(\$84,000-\$79,000\right)$ has not been paid at the year end. Hence, the amount of $5,000 is an accrued expense that would appear as current liability in the balance sheet.

b.

To determine

Calculate the (1) Current ratio, (2) Quick ratio, (3) Working capital, and (4) Debt ratio for Incorporation D.

Explanation of Solution

1. 1) 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. Current ratio is calculated by using the formula:

   $\text{Current ratio}=\frac{\text{Current Assets}}{\text{Current Liabilities}}$

2. 2) Quick 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. Quick ratio is calculated by using the formula:

$\text{Quick ratio}=\frac{\text{Quick Assets}}{\text{Current Liabilities}}$

1. 3) Working capital: Working capital refers to the excess amount of current assets over its current liabilities of a business. It measures the excess funds that are required for the companies to carry out their day to day operations, excluding any new funds that have been invested during the year. Working capital is calculated by using the formula:

$\text{Working Capital}=\text{Current Assets}-\text{Current Liabilities}$

1. 4) Debt ratio: The debt ratio shows the relationship between total asset and the total liability of the company. Debt ratio reflects the financial strategy of the company. It is used to measure the percentage of company’s assets that are financed by long term debts.  Debt to assets ratio is calculated by using the formula:

$\text{Debt-to-assets ratio}=\frac{\text{Total Liabilities}}{\text{Total Assets }}$

Calculate the (1) Current ratio, (2) Quick ratio, (3) Working capital, and (4) Debt ratio for Incorporation D.

Incorporation D
Particulars	Amount ($)
(1) Current ratio
Current Assets
Cash	30,000
Accounts receivable	150,000
Inventories	200,000
Current Assets (A)	$380,000
Current Liabilities (B)	150,000
Current ratio $\left(\text{A}\right)÷\left(\text{B}\right)$	2.5:1
(2) Quick ratio
Cash	30,000
Accounts receivable	150,000
Quick Assets (A)	$180,000
Current Liabilities (B)	150,000
Quick ratio $\left(\text{A}\right)÷\left(\text{B}\right)$	1.2:1
(3) Working capital
Current Assets	$380,000
Less: Current Liabilities	($150,000)
Working capital	$230,000
(4) Debt ratio
Total Assets	$1,000,000
Less: Total stockholders’ equity	($300,000)
Total liabilities (A)	$700,000
Total Assets (B)	$1,000,000
Debt ratio $\left(\text{A}\right)÷\left(\text{B}\right)$	70%

Table (1)

Hence, the (1) Current ratio, (2) Quick ratio, (3) Working capital, and (4) Debt ratio of Incorporation D is 2.5:1, 1.2:1, $230,000 , and  70% respectively.

c.

To determine

Comment on these measurements and evaluate Incorporation D’s short-term debt-paying ability.

Explanation of Solution

As per Table (1), the current ratio (2.5:1) and quick ratio (1.2:1) of Incorporation D is higher than the ideal ratios and are quite adequate. The working capital of Incorporation D is $230,000 and the debt ratio is 70% that is also quite significant. Overall, the short term debt paying ability of Incorporation D appears to be strong to repay the future obligations.

d.

To determine

Calculate the (1) return on average total assets and (2) return on average stockholders’ equity of Incorporation D.

Explanation of Solution

Return on equity: It is a profitability ratio that measures the profit generating ability of the company from the invested money of the shareholders. The formula to calculate the return on equity is as follows:

$\text{Return on equity}=\frac{\text{Net income}}{\text{Average total stockholders' equity}}\times 100$

Return on assets: This financial ratio evaluates the efficiency of management in utilizing the assets to generate operating income. This tool is used to measure the profitability of a company. The formula to calculate the return on equity is as follows

$\text{Return on assets = }\frac{\text{Operating income }}{\text{Average total assets}}\times 100$

Calculate the (1) return on assets and (2) return on equity of Incorporation D.

(1) Computation of return on assets
Particulars	Amount
Net sales	$1,500,000
Less: Cost of goods sold	($1,080,000)
Gross profit	$420,000
Less: Operating expense	($315,000)
Operating income (A)	$105,000
Average total assets (B)	$1,000,000
Return on assets $\left[\left(\text{A}\right)÷\left(\text{B}\right)\right]\times 100$	10.5%
(2) Computation of return on equity
Average total stockholders’ equity (A)	$300,000
Net income (B)	$15,000
Return on equity $\left[\left(\text{B}\right)÷\left(\text{A}\right)\right]\times 100$	5%

Table (2)

Hence, the return on assets and return on equity of Incorporation D is 10.5% and 5% respectively.

e.

To determine

Comment on the company’s performances under these measurements and explain the reasons behind the difference between return on assets and return on equity.

Explanation of Solution

• The return on assets and return on equity of Incorporation D is 10.5% and 5% respectively. The long term liabilities $\left(\text{Total assets}-\text{Total stockholders' equity}\right)$ of Incorporation D are $700,000$\left(\$1,000,000-\$300,000\right)$. Incorporation D’s major portion of financing depends upon the long term liabilities (70%) which is significantly larger than the return on equity (5%) and return on assets (10.5%) of Incorporation D.
• The major difference between the return on equity and return on asset is due to the interest expense of $84,000. Incorporation D had to pay $84,000 as interest expense that is deducted from the operating income of $105,000. This reduced the net income to $15,000 during the year. 

f.

To determine

Explain (1) the apparent safety of long-term creditors’ claims and (2) the prospects of Incorporation D to continue the payment of dividend at the present level.

Explanation of Solution

1. 1) Apparent safety of long-term creditors’ claims: The safety of long term creditors is very weak, as debt is rising continuously. The long term liabilities of Incorporation D has increased by $50,000 and also repaid the existing current liabilities of $14,000 during the year.
2. 2) Prospects of paying dividend: The net cash from operating activities of Incorporation D is $40,000 and the net cash used in investing activities is $46,000 that has severely affected the cash flows of the company. Although, Incorporation D has paid $20,000 as dividends during the year. If the current situation exists in future, then the payment of dividends to stockholders’ in the future periods would be affected.