Chapter 2, Problem 2.10MCP

A

To determine

Introduction: The ratios are calculated using the information available in the financial statements of a company. Such ratios help the users of the accounting information to understand the liquidity, profitability and other related aspects of a company.

To prepare: The ratios analysis model.

Explanation of Solution

1. Formulate the Question

How liquid is C and P Company?

2. Gather the information from the financial statements.

The current ratio is the ratio calculated by dividing current assets and current liabilities. Current ratio measures the liquidity of a company which tells how soon the company will be able to pay off the current debts using the current assets available. Both current assets and current liabilities are extracted from the information available in the balance sheet.

3. Calculate the ratio.

Current ratio of both the companies has been calculated below −

C Company

Current ratio (2015) = $\frac{\text{Current assets}}{\text{Current liabilities}}$

  $\begin{array}{l}\text{Current assets}=\text{Cash and cash equivalents}+\text{Inventories}+\text{Prepaid expenses}+\text{Marketable securities}+\\ \text{Short term investments}+\text{Accounts receivable}+\text{Assets held for sale}\\ =\$7,309+\$2,902+\$2,752+\$4,269+\$8,322+\$3,941+\$3,900\\ =\$33,395\end{array}$

  Current liabilities = $\begin{array}{l}\text{Accounts payable}+\text{Accrued income taxes}+\text{Current maturities of long term debt}+\text{Loans and notes payable}+\\ \text{Liabilities held for sale}\\ =\$9,660+\$331+\$2,677+\$13,129+\$1,133\\ =\$26,930\end{array}$

  $\begin{array}{l}\text{Current ratio}=\frac{\$33,395}{\$26,930}\\ =1.24\end{array}$

Current ratio (2014) = $\frac{\text{Current assets}}{\text{Current liabilities}}$

  $\begin{array}{l}\text{Current assets}=\text{Cash and cash equivalents}+\text{Inventories}+\text{Prepaid expenses}+\text{Marketable securities}+\\ \text{Short term investments}+\text{Accounts receivable}+\text{Assets held for sale}\\ =\$8,958+\$3,100+\$3,066+\$3,665+\$9,052+\$4,466+\$679\\ =\$32,986\end{array}$

  Current liabilities = $\begin{array}{l}\text{Accounts payable}+\text{Accrued income taxes}+\text{Current maturities of long term debt}+\text{Loans and notes payable}+\\ \text{Liabilities held for sale}\\ =\$9,234+\$400+\$3,552+\$19,130+\$58\\ =\$32,374\end{array}$

  $\begin{array}{l}\text{Current ratio}=\frac{\$32,986}{\$32,374}\\ =1.02\end{array}$

P Company

Current ratio (2015) = $\frac{\text{Current assets}}{\text{Current liabilities}}$

  $\begin{array}{l}\text{Current assets}=\text{Accounts receivable}+\text{Cash and cash equivalents}+\text{Inventories}+\text{Prepaid expenses}+\\ \text{Short term investments}\\ =\$6,437+\$9,096+\$2,720+\$1,865+\$2,913\\ =\$23,031\end{array}$

  $\begin{array}{l}\text{Current liabilities}=\text{Accounts payable}+\text{Short term obligation}\\ =\$13,507+\$4,071\\ =\$17,578\end{array}$

  $\begin{array}{l}\text{Current ratio}=\frac{\$23,031}{\$17,578}\\ =1.31\end{array}$

Current ratio (2014) = $\frac{\text{Current assets}}{\text{Current liabilities}}$

  $\begin{array}{l}\text{Current assets}=\text{Accounts receivable}+\text{Cash and cash equivalents}+\text{Inventories}+\text{Prepaid expenses}+\\ \text{Short term investments}\\ =\$6,651+\$6,134+\$3,143+\$2,143+\$2,592\\ =\$20,663\end{array}$

  $\begin{array}{l}\text{Current liabilities}=\text{Accounts payable}+\text{Short term obligation}\\ =\$13,016+\$5,076\\ =\$18,092\end{array}$

  $\begin{array}{l}\text{Current ratio}=\frac{\$20,663}{\$18,092}\\ =1.14\end{array}$

4. Compare the ratio with other ratios.

	2015	2014
C Company	1.24	1.02
P Company	1.31	1.14

5. Interpret the ratios

Current ratio of C Company has improved a bit from 1.02 in the year 2014 to 1.24 in 2015 which means the liquidity of the company has improved.

Current ratio of P Company has improved from 1.14 in 2014 to 1.31 in 2015.

B

To determine

Introduction: The ratios are calculated using the information available in the financial statements of a company. Such ratios help the users of the accounting information to understand the liquidity, profitability and other related aspects of a company.

To prepare: The business analysis model.

Explanation of Solution

1. Formulate the Question

Should loan be sanctioned to C Company?

2. Gather information from the financial statements and other sources

Taking decisions about lending a loan or not is a crucial one and hence a variety of factors should be kept in mind while deciding whether C Company should be provided the required loan or not. Such factors include assessing the information gathered from balance sheet, profit and loss accounts, cash flow statements, etc. All the investments made by the company should also be studied and the banker should also look for any defaults made by the company in the past. Such information will help the banker in deciding about sanctioning the loan or not.

3. Analyze the information gathered

Analyses of the information gathered so far includes comparing the current ratio of C Company with P Company. The banker should look at the trends over time in the current ratio.

4. Make the decision

Decision needs to be taken about the loan should be sanctioned or not. Since the current ratio of the company has improved from the previous year and debts mentioned in the balance sheet are not that huge and can be paid off using the current assets, this suggests that the company has better liquidity. But only liquidity factor is not a good measure to decide about lending a loan or not, so the banker needs to look at profitability and other factors as well.

5. Monitor the decision

If the banker extends the loan, then periodic monitoring will be required and continuous analysis of the financial statements will also be required to identify the liquidity and credit paying capacity of the firm.