Chapter 14, Problem 9PA

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 9PA

The ratios for each of the companies are as follows:

Ratios	Incorporation AW	Incorporation I
1. Working capital
Cash	$53,000	$22,000
Accounts receivable (net)	$75,000	$70,000
Inventory	$84,000	$160,000
Current Assets (A) (1)	$212,000	$252,000
Current Liabilities (B)	$105,000	$100,000
Working capital $\left(\text{A}\right)-\left(\text{B}\right)$	$107,000	$152,000
2. Current ratio
Current Assets (A) (1)	$212,000	$252,000
Current Liabilities (B)	$105,000	$100,000
Current ratio $\left(\text{A}\right)÷\left(\text{B}\right)$	2.0:1	2.5:1
3. Quick ratio
Cash	$53,000	$22,000
Accounts receivable (net)	$75,000	$70,000
Quick Assets (A)	$128,000	$92,000
Current Liabilities (B)	$105,000	$100,000
Quick ratio $\left(\text{A}\right)÷\left(\text{B}\right)$	1.2:1	0.9:1
4. Number of times inventory turned over and average number of days to sell
Cost of goods sold (A)	$504,000	$480,000
Average inventory  (B)	$84,000	$160,000
Number of times inventory turned over $\left(\text{A}\right)÷\left(\text{B}\right)$ (2)	6.0 Times	3.0 Times
Number of times inventory turned over (C) (2)	6.0 Times	3.0 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)	61 days	122 days
5. Number of times accounts receivable turned over and average number of days to collect receivable
Sales (A)	$675,000	$560,000
Average accounts receivable  (B)	$75,000	$70,000
Number of times accounts receivable turned over $\left(\text{A}\right)÷\left(\text{B}\right)$(4)	9.0 Times	8.0 Times
Number of times accounts receivable turned over (C) (4)	9.0 Times	8.0 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	46 days
6. Operating cycle
Number of days to sell inventory (A) (3)	61 days	122 days
Number of days to collect receivable (B) (5)	41 days	46 days
Operating cycle $\left(\text{A}\right)+\left(\text{B}\right)$	102 days	168 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 AW	Incorporation I
1. Working capital.	$107,000	$152,000
2. Current ratio.	2.0:1	2.5:1
3. Quick ratio.	1.2	0.9
4. Number of times inventory turned over.	6.0 Times	3.0 Times
Average number of days to sell inventory.	61 days	122 days
5. Number of times accounts receivable turned over.	9.0 Times	8.0 Times
Average number of days to collect receivable.	41 days	46 days
6. Operating cycle	102 days	168 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 $25,000 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 I is higher than the working capital of Incorporation AW.
• The quick ratio of Incorporation I is lower than the quick ratio of Incorporation AW because the major portion of current assets of Incorporation I consists of inventories that has blocked the cash inflow.
• The number of times inventory turned over and the number of times accounts receivable turned over of Incorporation AW is higher than the turnover ratios of Incorporation I.
• Similarly, Incorporation AW’s average number of days to sell inventory and number of days to collect receivable is also lower than Incorporation I that indicates Incorporation AW has been managing its collections and inventory level efficiently. Although, the operating cycle of Incorporation I is higher than the operating cycle of Incorporation AW.

Incorporation AW would be preferred to sell merchandise worth of $25,000 because Incorporation AW has a greater potential for paying off the obligations when it becomes due.