Chapter 16, Problem 3PB

1(a)

To determine

Financial Ratios: Financial ratios are the metrics used to evaluate the liquidity, capabilities, profitability, and overall performance of a company.

To compute: Working capital

Given info: Total current assets and current liabilities.

Explanation of Solution

Compute working capital.

$\begin{array}{c}\text{Working}\text{capital}=\text{Current assets}–\text{Current liabilities}\\ \text{= }\text{}\text{\$3,200,000 – \$2,000,000}\\ \text{=\$1,200,000}\end{array}$

Working capital is the difference between current assets and current liabilities. 

Formula:

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

Conclusion

Thus, working capital is $1,200,000.

1(b)

To determine

To compute: Current ratio

Given info: Total current assets and current liabilities.

Explanation of Solution

Compute current ratio.

$\begin{array}{c}\text{Current ratio}=\frac{\text{Current assets}}{\text{Current liabilities}}\\ =\frac{\$3,200,000}{\$2,000,000}\\ =1.6\end{array}$

Current Ratio: Current ratio is used to determine the relationship between current assets and current liabilities. Current ratio is determined by dividing current assets and current liabilities.

Formula:

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

The ideal current ratio is 2:1.

Current assets and current liabilities are determined as follows:

$\begin{array}{c}\text{Current assets = }\left(\begin{array}{l}\text{Cash + Marketable securities }\\ \text{+ Accounts receivable }\left(\text{net}\right)\\ +\text{Inventory + Prepaid expenses}\end{array}\right)\\ =\$800,000+\$550,000+\$850,000+\$700,000+\$300,000\\ =\$3,200,000\end{array}$

$\begin{array}{c}\text{Current liabilities = }\left(\begin{array}{l}\text{Accounts payable + Notes payable }\left(\text{Short-term}\right)\\ +\text{Accrued expenses}\end{array}\right)\\ =\$1,200,000+\$700,000+\$100,000\\ =\$2,000,000\end{array}$

Conclusion

Thus, current ratio is 1.6.

1(c)

To determine

Acid-Test Ratio: This ratio denotes that this ratio is a more rigorous test of solvency than the current ratio. It is determined by dividing quick assets and current liabilities. The acceptable acid-test ratio is 0.90 to 1.00. Use the following formula to determine the acid-test ratio:

$\text{Acid Ratio}=\frac{\text{Quick assets}}{\text{Current}\text{liabilities}}$

Quick Assets are those assets that are most liquid. The examples of quick assets include cash and bank balances, marketable securities, and sundry debtors.

To calculate: Acid-test ratio

Given info: Current assets and current liabilities

Explanation of Solution

Compute quick ratio.

$\begin{array}{c}\text{Quick ratio}=\frac{\text{Quick assets}}{\text{Current}\text{liabilities}}\\ =\frac{\$2,000,000}{\$2,000,000}\\ =1.1\end{array}$

First, determine the quick assets as shown below:

$\begin{array}{c}\text{Quick assets = }\left(\begin{array}{l}\text{Cash + Marketable securities }\\ \text{+ Accounts receivable }\left(\text{net}\right)\end{array}\right)\\ =\$800,000+\$550,000+\$850,000\\ =\$2,000,000\end{array}$

$\begin{array}{c}\text{Current liabilities = }\left(\begin{array}{l}\text{Accounts payable + Notes payable }\left(\text{Short-term}\right)\\ +\text{Accrued expenses}\end{array}\right)\\ =\$1,200,000+\$700,000+\$100,000\\ =\$2,000,000\end{array}$

Then, determine acid-test ratio by dividing quick assets and current liabilities. Accounts payable are the only current liabilities.

Conclusion

Thus, quick ratio is 1.1.

To determine

To compute: Working capital, Current ratio, and Quick ratio considering the given transactions.

Explanation of Solution

2(a)

Sale of marketable securities at no gain or loss, $500,000.

When sale of marketable securities is considered, it increases the cash and decreases the marketable securities by same amount. So, there is no effect in the working capital, current ratio, and quick ratios that are calculated in the requirement 1. Thus, working capital, current ratio, and quick ratio are determined as follows:

Ratios	Working capital	Current ratio	Quick ratio
	$1,200,000	1.6	1.1

2(b)

Payment of accounts payable at $287,500.

Payment of accounts payable involves cash and accounts payable accounts. It decreases the accounts payable and cash. Cash is a current asset and accounts payable is a current liability. Both are the decreased by $287,500.

Determine the new current assets, quick assets, and current liabilities as below:

$\begin{array}{c}\text{Current assets = }\left(\begin{array}{l}\text{Cash + Marketable securities }\\ \text{+ Accounts receivable }\left(\text{net}\right)\\ +\text{Inventory + Prepaid expenses}\end{array}\right)–\text{Decrease}\text{in}\text{cash}\\ =\left(\begin{array}{l}\$800,000+\$550,000+\$850,000\\ +\$700,000+\$300,000\end{array}\right)-\$287,500\\ =\$2,912,500\end{array}$

$\begin{array}{c}\text{Quick assets = }\left(\begin{array}{l}\text{Cash + Marketable securities }\\ \text{+ Accounts receivable }\left(\text{net}\right)\end{array}\right)–\text{Decrease}\text{in}\text{cash}\\ =\left(\$800,000+\$550,000+\$850,000\right)-\$287,500\\ =\$1,912,500\end{array}$

$\begin{array}{c}\text{Current liabilities = }\left(\begin{array}{l}\text{Accounts payable + Notes payable }\left(\text{Short-term}\right)\\ +\text{Accrued expenses}\end{array}\right)–\left(\begin{array}{l}\text{Decrease in}\\ \text{ accounts payable }\end{array}\right)\\ =\left(\$1,200,000+\$700,000+\$100,000\right)-\$287,500\\ =\$1,712,500\end{array}$

Thus, ratios are determined as follows:

Compute working capital.

$\begin{array}{c}\text{Current ratio}=\text{Current assets}–\text{Current liabilities}\\ \text{= }\text{}\$2,912,500–\$1,912,500\\ \text{=\$1,200,000}\end{array}$

Compute current ratio.

$\begin{array}{c}\text{Current ratio}=\frac{\text{Current assets}}{\text{Current liabilities}}\\ =\frac{\$2,912,500}{\$1,712,500}\\ =1.7\end{array}$

Compute quick ratio.

$\begin{array}{c}\text{Quick ratio}=\frac{\text{Quick assets}}{\text{Current}\text{liabilities}}\\ =\frac{\$1,912,500}{\$1,712,500}\\ =1.1\end{array}$

2(c)

Purchase of goods on account $400,000.

Purchase of goods on account involves Merchandise inventory and accounts payable account. Merchandise inventory is a current asset and it is increased due to purchases made. Accounts payable is increased due to purchases made on account. So, both are increased by $400,000.  

Determine the new current assets, quick assets, and current liabilities as below:

$\begin{array}{c}\text{Current assets = }\left(\begin{array}{l}\text{Cash + Marketable securities }\\ \text{+ Accounts receivable }\left(\text{net}\right)\\ +\text{Inventory + Prepaid expenses}\end{array}\right)–\text{Increase in inventory}\\ =\left(\begin{array}{l}\$800,000+\$550,000+\$850,000\\ +\$700,000+\$300,000\end{array}\right)-\$400,000\\ =\$3,600,000\end{array}$

$\begin{array}{c}\text{Quick assets = }\left(\begin{array}{l}\text{Cash + Marketable securities }\\ \text{+ Accounts receivable }\left(\text{net}\right)\end{array}\right)\\ =\left(\$800,000+\$550,000+\$850,000\right)\\ =\$2,200,000\end{array}$

$\begin{array}{c}\text{Current liabilities = }\left(\begin{array}{l}\text{Accounts payable + Notes payable }\left(\text{Short-term}\right)\\ +\text{Accrued expenses}\end{array}\right)+\left(\begin{array}{l}\text{Increase in}\\ \text{ accounts payable }\end{array}\right)\\ =\left(\$1,200,000+\$700,000+\$100,000\right)+\$400,000\\ =2,400,000\end{array}$

Thus, ratios are determined as follows:

Compute working capital.

$\begin{array}{c}\text{Working}\text{capital=Current assets}–\text{Current liabilities}\\ \text{= }\text{}\text{\$3,600,000 – \$2,400,000}\\ \text{=\$1,200,000}\end{array}$

Compute current ratio.

$\begin{array}{c}\text{Current ratio}=\frac{\text{Current assets}}{\text{Current liabilities}}\\ =\frac{\$3,600,000}{\$2,400,000}\\ =1.5\end{array}$

Compute quick ratio.

$\begin{array}{c}\text{Quick ratio}=\frac{\text{Quick assets}}{\text{Current}\text{liabilities}}\\ =\frac{\$2,200,000}{\$2,400,000}\\ =0.9\end{array}$

2(d)

Payment of notes payable $125,000.

Notes payable involves notes payable and cash. Notes payable is a current liability and is decreased. Cash is a current asset and decreased due to payment made. So, reduce notes payable and cash by $125,000.

Determine the new current assets, quick assets, and current liabilities as below:

$\begin{array}{c}\text{Current assets = }\left(\begin{array}{l}\text{Cash + Marketable securities }\\ \text{+ Accounts receivable }\left(\text{net}\right)\\ +\text{Inventory + Prepaid expenses}\end{array}\right)–\text{Decrease}\text{in}\text{cash}\\ =\left(\begin{array}{l}\$800,000+\$550,000+\$850,000\\ +\$700,000+\$300,000\end{array}\right)-\$125,000\\ =\$3,075,000\end{array}$

$\begin{array}{c}\text{Quick assets = }\left(\begin{array}{l}\text{Cash + Marketable securities }\\ \text{+ Accounts receivable }\left(\text{net}\right)\end{array}\right)–\text{Decrease}\text{in}\text{cash}\\ =\left(\$800,000+\$550,000+\$850,000\right)-\$125,000\\ =\$2,075,000\end{array}$

$\begin{array}{c}\text{Current liabilities = }\left(\begin{array}{l}\text{Accounts payable + Notes payable }\left(\text{Short-term}\right)\\ +\text{Accrued expenses}\end{array}\right)–\left(\begin{array}{l}\text{Decrease in}\\ \text{ notes payable }\end{array}\right)\\ =\left(\$1,200,000+\$700,000+\$100,000\right)-\$125,000\\ =\$1,875,000\end{array}$

Thus, ratios are determined as follows:

Compute working capital.

$\begin{array}{c}\text{Working}\text{capital=Current assets}–\text{Current liabilities}\\ \text{= \$3,075,000 – \$1,875,000}\\ \text{=\$1,200,000}\end{array}$

Compute current ratio.

$\begin{array}{c}\text{Current ratio}=\frac{\text{Current assets}}{\text{Current liabilities}}\\ =\frac{\$3,075,000}{\$2,400,000}\\ =1.6\end{array}$

Compute quick ratio.

$\begin{array}{c}\text{Quick ratio}=\frac{\text{Quick assets}}{\text{Current}\text{liabilities}}\\ =\frac{\$2,075,000}{\$1,875,000}\\ =1.1\end{array}$

2(e)

Cash dividend of $325,000 was declared.

Cash dividends involve cash dividends and dividends payable. Cash dividends are a stockholders’ equity. Dividend payable is a current liability and is increased.

Determine the new current assets, quick assets, and current liabilities as below:

$\begin{array}{c}\text{Current assets = }\left(\begin{array}{l}\text{Cash + Marketable securities }\\ \text{+ Accounts receivable }\left(\text{net}\right)\\ +\text{Inventory + Prepaid expenses}\end{array}\right)\\ =\$800,000+\$550,000+\$850,000+\$700,000+\$300,000\\ =\$3,200,000\end{array}$

$\begin{array}{c}\text{Quick assets = }\left(\begin{array}{l}\text{Cash + Marketable securities }\\ \text{+ Accounts receivable }\left(\text{net}\right)\end{array}\right)\\ =\left(\$800,000+\$550,000+\$850,000\right)\\ =\$2,200,000\end{array}$

$\begin{array}{c}\text{Current liabilities = }\left[\begin{array}{l}\left(\begin{array}{l}\text{Accounts payable + Notes payable }\left(\text{Short-term}\right)\\ +\text{Accrued expenses}\end{array}\right)\\ +\text{Increase in accounts payable}\end{array}\right]\\ =\$1,200,000+\$700,000+\$100,000+\$325,000\\ =\$2,325,000\end{array}$

Thus, ratios are determined as follows:

Compute working capital.

$\begin{array}{c}\text{Working}\text{capital=Current assets}–\text{Current liabilities}\\ \text{= }\text{}\text{\$3,200,000– \$2,325,000}\\ \text{=\$875,000}\end{array}$

Compute current ratio.

$\begin{array}{c}\text{Current ratio}=\frac{\text{Current assets}}{\text{Current liabilities}}\\ =\frac{\$3,200,000}{\$2,325,000}\\ =1.4\end{array}$

Compute quick ratio.

$\begin{array}{c}\text{Quick ratio}=\frac{\text{Quick assets}}{\text{Current}\text{liabilities}}\\ =\frac{\$2,200,000}{\$2,325,000}\\ =0.9\end{array}$

2(f)

Declaration of common stock dividend on common stock, $150,000.

Common stock dividend declaration involves common stock dividends and dividends payable. Common stock dividends are a stockholders’ equity. Dividend payable is a current liability and is increased.

Determine the new current assets, quick assets, and current liabilities as below:

$\begin{array}{c}\text{Current assets = }\left(\begin{array}{l}\text{Cash + Marketable securities }\\ \text{+ Accounts receivable }\left(\text{net}\right)\\ +\text{Inventory + Prepaid expenses}\end{array}\right)\\ =\$800,000+\$550,000+\$850,000+\$700,000+\$300,000\\ =\$3,200,000\end{array}$

$\begin{array}{c}\text{Quick assets = }\left(\begin{array}{l}\text{Cash + Marketable securities }\\ \text{+ Accounts receivable }\left(\text{net}\right)\end{array}\right)\\ =\left(\$800,000+\$550,000+\$850,000\right)\\ =\$2,200,000\end{array}$

$\begin{array}{c}\text{Current liabilities = }\left(\begin{array}{l}\text{Accounts payable + Notes payable }\left(\text{Short-term}\right)\\ +\text{Accrued expenses}\end{array}\right)\\ =\$1,200,000+\$700,000+\$100,000\\ =\$2,000,000\end{array}$

Thus, ratios are determined as follows:

Compute working capital.

$\begin{array}{c}\text{Working}\text{capital=Current assets}–\text{Current liabilities}\\ \text{= }\text{}\$3,200,\text{000 – \$2,200,000}\\ \text{=\$1,000,000}\end{array}$

Compute current ratio.

$\begin{array}{c}\text{Current ratio}=\frac{\text{Current assets}}{\text{Current liabilities}}\\ =\frac{\$3,200,000}{\$2,000,000}\\ =1.6\end{array}$

Compute quick ratio.

$\begin{array}{c}\text{Quick ratio}=\frac{\text{Quick assets}}{\text{Current}\text{liabilities}}\\ =\frac{\$2,200,000}{\$2,000,000}\\ =1.1\end{array}$

2(g)

Borrowal of cash from bank on a long-term note for $1,000,000.

Borrowal of cash from bank on a long-term note involves cash and long-term notes payable. Cash is a current asset and is increased due to borrowable of cash. Note is a long-term note and long-term liability is increased. So, only current assets and working capital  is affected.

Determine the new current assets, quick assets, and current liabilities as below:

$\begin{array}{c}\text{Current assets = }\left(\begin{array}{l}\text{Cash + Marketable securities }\\ \text{+ Accounts receivable }\left(\text{net}\right)\\ +\text{Inventory + Prepaid expenses}\end{array}\right)+\text{Increase in cash }\\ =\left(\begin{array}{l}\$800,000+\$550,000\\ +\$850,000+\$700,000\\ +\$300,000\end{array}\right)+\$1,000,000\\ =\$4,200,000\end{array}$

$\begin{array}{c}\text{Quick assets = }\left(\begin{array}{l}\text{Cash + Marketable securities }\\ \text{+ Accounts receivable }\left(\text{net}\right)\end{array}\right)+\text{Increase in cash }\\ =\left(\$800,000+\$550,000+\$850,000\right)+\$1,000,000\\ =\$3,200,000\end{array}$

$\begin{array}{c}\text{Current liabilities = }\left(\begin{array}{l}\text{Accounts payable + Notes payable }\left(\text{Short-term}\right)\\ +\text{Accrued expenses}\end{array}\right)\\ =\$1,200,000+\$700,000+\$100,000\\ =\$2,000,000\end{array}$

Thus, ratios are determined as follows:

Compute working capital.

$\begin{array}{c}\text{Working}\text{capital=Current assets}–\text{Current liabilities}\\ \text{= }\text{}\text{\$4,200,000– \$2,000,000}\\ \text{=\$2,200,000}\end{array}$

Compute current ratio.

$\begin{array}{c}\text{Current ratio}=\frac{\text{Current assets}}{\text{Current liabilities}}\\ =\frac{\$4,200,000}{\$2,000,000}\\ =2.1\end{array}$

Compute quick ratio.

$\begin{array}{c}\text{Quick ratio}=\frac{\text{Quick assets}}{\text{Current}\text{liabilities}}\\ =\frac{\$3,200,000}{\$2,000,000}\\ =1.6\end{array}$

2(h)

Received cash on account, $75,000.

Receipt of cash on account is $75,000. Cash and accounts receivable are assets. Cash is an asset and increases due to receipt of cash. Accounts receivable is an asset and is decreased. So, there is no effect of this transaction. 

Determine the new current assets, quick assets, and current liabilities as below:

$\begin{array}{c}\text{Current assets = }\left(\begin{array}{l}\text{Cash + Marketable securities }\\ \text{+ Accounts receivable }\left(\text{net}\right)\\ +\text{Inventory + Prepaid expenses}\end{array}\right)\\ =\$800,000+\$550,000+\$850,000+\$700,000+\$300,000\\ =\$3,200,000\end{array}$

$\begin{array}{c}\text{Quick assets = }\left(\begin{array}{l}\text{Cash + Marketable securities }\\ \text{+ Accounts receivable }\left(\text{net}\right)\end{array}\right)\\ =\left(\$800,000+\$550,000+\$850,000\right)\\ =\$2,200,000\end{array}$

$\begin{array}{c}\text{Current liabilities = }\left(\begin{array}{l}\text{Accounts payable + Notes payable }\left(\text{Short-term}\right)\\ +\text{Accrued expenses}\end{array}\right)\\ =\$1,200,000+\$700,000+\$100,000\\ =\$2,000,000\end{array}$

Thus, ratios are determined as follows:

Compute working capital.

$\begin{array}{c}\text{Working capital}=\text{Current assets}–\text{Current liabilities}\\ \text{= }\text{}\text{\$3,200,000 – \$2,000,000}\\ \text{=\$1,200,000}\end{array}$

Compute current ratio.

$\begin{array}{c}\text{Current ratio}=\frac{\text{Current assets}}{\text{Current liabilities}}\\ =\frac{\$3,200,000}{\$2,000,000}\\ =1.6\end{array}$

Compute quick ratio.

$\begin{array}{c}\text{Quick ratio}=\frac{\text{Quick assets}}{\text{Current}\text{liabilities}}\\ =\frac{\$2,000,000}{\$2,000,000}\\ =1.1\end{array}$

2(i)

Issue of additional shares of stock for cash, $2,000,000.

Issue of additional shares of stock for cash involves Cash and common stock. Cash is an asset and increases due to issue of additional shares. Common stock is a stock and is increases. So, this affects common stock.  

Determine the new current assets, quick assets, and current liabilities as below:

$\begin{array}{c}\text{Current assets = }\left(\begin{array}{l}\text{Cash + Marketable securities }\\ \text{+ Accounts receivable }\left(\text{net}\right)\\ +\text{Inventory + Prepaid expenses}\end{array}\right)+\text{Increase}\text{in}\text{cash}\\ =\left(\begin{array}{l}\$800,000+\$550,000+\$850,000\\ +\$700,000+\$300,000\end{array}\right)+\$2,000,000\\ =\$3,200,000+\$2,000,000\\ =\$5,200,000\end{array}$

$\begin{array}{c}\text{Quick assets = }\left(\begin{array}{l}\text{Cash + Marketable securities }\\ \text{+ Accounts receivable }\left(\text{net}\right)\end{array}\right)+\text{Increase in cash }\\ =\left(\$800,000+\$550,000+\$850,000\right)+\$2,000,000\\ =\$4,200,000\end{array}$

$\begin{array}{c}\text{Current liabilities = }\left(\begin{array}{l}\text{Accounts payable + Notes payable }\left(\text{Short-term}\right)\\ +\text{Accrued expenses}\end{array}\right)\\ =\$1,200,000+\$700,000+\$100,000\\ =\$2,000,000\end{array}$

Thus, ratios are determined as follows:

Compute working capital.

$\begin{array}{c}\text{Working capital}=\text{Current assets}–\text{Current liabilities}\\ \text{= }\text{}\text{\$5,200,000 – \$2,000,000}\\ \text{=\$3,200,000}\end{array}$

Compute current ratio.

$\begin{array}{c}\text{Current ratio}=\frac{\text{Current assets}}{\text{Current liabilities}}\\ =\frac{\$5,200,000}{\$2,000,000}\\ =2.6\end{array}$

Compute quick ratio.

$\begin{array}{c}\text{Quick ratio}=\frac{\text{Quick assets}}{\text{Current}\text{liabilities}}\\ =\frac{\$4,200,000}{\$2,000,000}\\ =2.1\end{array}$

2(j)

Payment of cash for prepaid expenses, $200,000.

Payment of cash for prepaid expenses involves prepaid expenses and cash. Prepaid expenses are asset. Prepaid expenses decrease and cash decreases. Thus, there is no effect.

Determine the new current assets, quick assets, and current liabilities as below:

$\begin{array}{c}\text{Current assets = }\left(\begin{array}{l}\text{Cash + Marketable securities }\\ \text{+ Accounts receivable }\left(\text{net}\right)\\ +\text{Inventory + Prepaid expenses}\end{array}\right)\\ =\$800,000+\$550,000+\$850,000+\$700,000+\$300,000\\ =\$3,200,000\end{array}$

$\begin{array}{c}\text{Quick assets = }\left(\begin{array}{l}\text{Cash + Marketable securities }\\ \text{+ Accounts receivable }\left(\text{net}\right)\end{array}\right)–\text{Decrease in prepaid expensses}\\ =\left(\$800,000+\$550,000+\$850,000\right)-\$200,000\\ =\$2,000,000\end{array}$

$\begin{array}{c}\text{Current liabilities = }\left(\begin{array}{l}\text{Accounts payable + Notes payable }\left(\text{Short-term}\right)\\ +\text{Accrued expenses}\end{array}\right)\\ =\$1,200,000+\$700,000+\$100,000\\ =\$2,000,000\end{array}$

Thus, ratios are determined as follows:

Compute working capital.

$\begin{array}{c}\text{Working}\text{capital=Current assets}–\text{Current liabilities}\\ \text{= }\text{}\text{\$3,200,000 – \$2,000,000}\\ \text{=\$1,200,000}\end{array}$

Compute current ratio.

$\begin{array}{c}\text{Current ratio}=\frac{\text{Current assets}}{\text{Current liabilities}}\\ =\frac{\$3,200,000}{\$2,000,000}\\ =1.6\end{array}$

Compute quick ratio.

$\begin{array}{c}\text{Quick ratio}=\frac{\text{Quick assets}}{\text{Current}\text{liabilities}}\\ =\frac{\$2,000,000}{\$2,000,000}\\ =1.0\end{array}$

Conclusion

The calculated ratios are as follows:

Transaction	Working capital	Current ratio	Quick ratio
a.	$1,200,000	1.6	1.1
b.	$1,200,000	1.7	1.1
c.	$1,200,000	1.5	0.9
d.	$1,200,000	1.6	1.1
e.	$875,000	1.4	0.9
f.	$1,200,000	1.6	1.1
g.	$2,200,000	2.1	1.6
h.	$1,200,000	1.6	1.1
i.	$3,200,000	2.6	2.1
j.	$1,200,000	1.6	1.0