Chapter 14, Problem 9BP

a.

To determine

Compute the ratios for each of the companies.

1. Working capital.

2. Current ratio.

3. Quick ratio.

4. Number of times inventory turned over during the year and the average number of days required to turn over inventory.

5. Number of times accounts receivable turned over during the year and the average number of days required to collect accounts receivable.

6. Operating cycle.

Answer to Problem 9BP

Computation of ratios for each of the companies is as follows:

Ratios	Incorporation TIS	Incorporation TAS
1. Working capital
Cash	$95,000	$47,000
Accounts receivable (net)	$100,000	$90,000
Inventory	$50,000	$160,000
Current Assets (A) (1)	$245,000	$297,000
Current Liabilities (B)	$120,000	$110,000
Working capital $\left(\text{A}\right)-\left(\text{B}\right)$	$125,000	$187,000
2. Current ratio
Current Assets (A) (1)	$245,000	$297,000
Current Liabilities (B)	$120,000	$110,000
Current ratio $\left(\text{A}\right)÷\left(\text{B}\right)$	2.04:1	2.7:1
3. Quick ratio
Cash	$95,000	$47,000
Accounts receivable (net)	$100,000	$90,000
Quick Assets (A)	$195,000	$137,000
Current Liabilities (B)	$120,000	$110,000
Quick ratio $\left(\text{A}\right)÷\left(\text{B}\right)$	1.63:1	1.25:1
4. Number of times inventory turned over and average number of days to sell
Cost of goods sold (A)	$700,000	$640,000
Average inventory  (B)	$50,000	$160,000
Number of times inventory turned over $\left(\text{A}\right)÷\left(\text{B}\right)$ (2)	14.0 Times	4.0 Times
Number of times inventory turned over (C) (2)	14.0 Times	4.0 Times
Days in a year (D)	365 days	365 days
Average number of days to sell $\left(\text{D}\right)÷\left(\text{C}\right)$ (3)	26 days	91 days
5. Number of times accounts receivable turned over and average number of days to collect receivable
Sales (A)	$900,000	$840,000
Average accounts receivable  (B)	$100,000	$90,000
Number of times accounts receivable turned over $\left(\text{A}\right)÷\left(\text{B}\right)$(4)	9.0 Times	9.33 Times
Number of times accounts receivable turned over (C) (4)	9.0 Times	9.33 Times
Days in a year (D)	365 days	365 days
Average number of days required to collect receivable $\left(\text{D}\right)÷\left(\text{C}\right)$ (5)	41 days	39 days
6. Operating cycle
Number of days to sell inventory (A) (3)	26 days	91 days
Number of days to collect receivable (B) (5)	41 days	39 days
Operating cycle $\left(\text{A}\right)+\left(\text{B}\right)$	67 days	130 days

Table (1)

Explanation of Solution

1. 1) 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. 2) 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:

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

1. 3) 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. 4) Number of times inventory turned over: This is a financial measure that is used to evaluate as to how many times a company sells or uses its inventory during an accounting period. It is calculated by using the following formula:

$\begin{array}{l}\text{Number of times}\\ \text{ inventory turned over}\end{array}\}\text{ = }\frac{\text{Cost of goods sold}}{\text{Average inventory}}$

Average number of days to sell: This ratio is determined as the number of days a particular company takes to make sales of the inventory available with them. It is calculated by using the formula:

$\begin{array}{l}\text{Numbers of days }\\ \text{to sell inventory}\end{array}\}=\frac{\text{365}}{\text{Inventory turnover}}$

1. 5) Number of times accounts receivable turned over: Number of times accounts receivable turned over 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 average accounts receivable.

$\begin{array}{l}\text{Number of times accounts}\\ \text{ receivable turned over}\end{array}\}=\frac{\text{}\text{Net credit sales}}{\text{Average accounts receivables}}$

Average number of days to collect receivable: This ratio is used to determine the number of days a particular company takes to collect accounts receivables. It is calculated by using the formula:

$\begin{array}{l}\text{Average days to collect}\\ \text{ accounts receivable}\end{array}\}=\frac{\text{365}}{\text{Receivables turnover}}$

1. 6) Operating cycle: This ratio is used to determine the number of days a particular company takes to convert its invested cash into inventory and then converts the inventory back to cash. This ratio is calculated by using the formula:

$\text{Operating cycle}=\left(\begin{array}{l}\text{Number of days}\\ \text{ to sell inventory}\end{array}\right)+\left(\begin{array}{l}\text{Number of days}\\ \text{ to collect receivable}\end{array}\right)$

Conclusion

As per table (1), the ratios of each company are as follows:

Particulars	Incorporation TIS	Incorporation TAS
1. Working capital.	$125,000	$187,000
2. Current ratio.	2.04:1	2.70:1
3. Quick ratio.	1.63:1	1.25:1
4. Number of times inventory turned over.	14.0 Times	4.0 Times
Average number of days to sell inventory.	26 days	91 days
5. Number of times accounts receivable turned over.	9.0 Times	9.33 Times
Average number of days to collect receivable.	41 days	39 days
6. Operating cycle	67 days	130 days

Table (2)

b.

To determine

Comment on the quality of each company’s working capital from the viewpoint of a short term creditor and identify the company that would be preferred for the sale of $50,000 in merchandise on a 30-day open account.

Explanation of Solution

From the viewpoint of creditors, the following points must be considered:

• As per table (2), the current ratio and working capital of Incorporation TAS is higher than the working capital of Incorporation TIS.
• The quick ratio of Incorporation TAS is lower than the quick ratio of Incorporation TIS because the major portion of current assets of Incorporation TAS consists of inventories that have blocked the cash inflow.
• The number of times inventory turned over of Incorporation TIS is higher than the turnover ratio Incorporation TAS, whereas the number of times accounts receivable turned over of Incorporation TIS is lower than the turnover ratio of Incorporation TAS.
• Similarly, Incorporation TIS’s average number of days to sell inventory is lower than Incorporation TAS that indicates Incorporation TIS has been managing its inventory level efficiently.
• The number of days to collect receivable of Incorporation TAS is lower than Incorporation TIS that indicates Incorporation TAS has been managing its collections efficiently. Although, the operating cycle of Incorporation TAS is higher than the operating cycle of Incorporation TIS.

Incorporation TIS would be preferred to sell merchandise worth of $50,000 because Incorporation TIS has a greater potential for paying off the obligations when it becomes due.