Chapter 3, Problem 3.17E

(1) (a)

To determine

Ratio analysis

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

To Determine: (a)Current ratio, (b) acid test ratio, (c) debt equity ratio (d) times interest earned ratio.

Answer to Problem 3.17E

Determine the current ratio of Corporation BB’s.

$\begin{array}{c}\text{Current ratio= }\frac{\text{Current assets}}{\text{Current liabilities}}\\ =\frac{\$9,886}{\$6,925}\\ =1.437\end{array}$

Hence, the current ratio is 1.437.

Explanation of Solution

Current ratio

Current ratio is used to determine the relationship between current assets and current liabilities. The ideal current ratio is 2:1. Current assets of the company include cash, accounts receivable, and inventory. The only current liability of the bank is accounts payable.

Formula:

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

(1) (b)

To determine

 the acid test ratio of Corporation BB’s

Answer to Problem 3.17E

$\begin{array}{c}\text{Acid test ratio= }\frac{\text{Quick assets}}{\text{Current liabilities}}\\ \text{= }\frac{\left(\begin{array}{l}\text{Cash and cash equivalents +Short term investments +}\\ \text{Accounts receivable (net) }\end{array}\right)}{\text{Current liabilities}}\\ =\frac{\$1,976+\$1,305+\$1,162}{\$6,925}\\ =\frac{\$4,443}{\$6,925}\\ =0.64\end{array}$

Hence, the Acid test ratio is 0.64.

Explanation of Solution

Acid test ratio

Acid test ratio is a ratio which is likely to be modifying the current ratioto consider only the current assets which are ready to pay current liabilities. Acid test ratio is calculated by excluding the inventories, prepaid expenses, restricted cash and deferred taxes from current assets before dividing by current liabilities. It is also called as liquid ratio or quick ratio.

Formula:

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

(1) (c)

To determine

the debt to equity ratio of corporation BB’s

Answer to Problem 3.17E

$\begin{array}{c}\text{Debt-equity ratio = }\frac{\text{Total liabilities}}{\text{Total shareholders' equity}}\\ =\frac{\text{Total current liabilities + Long term liabilities}}{\text{Total shareholders' equity}}\\ =\frac{\$6,925+\$2,216}{\$4,378}\\ =\frac{\$9,141}{\$4,378}\\ =2.09\end{array}$

Hence, the debt to equity ratio is 2.09.

Explanation of Solution

Debt equity ratio

Debt equity ratio is a financial ratio indicating relative proportion of shareholders’ equity and total liabilities (i.e. current and long term liabilities).

Formula:

$\text{Debt-equity ratio=}\frac{\text{Total liabilities}}{\text{Total shareholders'equity}}$

(1) (d)

To determine

 the times interest earned ratio of corporation BB’s

Answer to Problem 3.17E

$\begin{array}{c}\text{Times interest earned ratio= }\frac{\text{Earnings before interest and tax}}{\text{Total interest payable}}\\ =\left(\frac{\begin{array}{l}\text{Net income + Interest expense}\\ \text{ + Income tax expense}\end{array}}{\text{Total interest payable}}\right)\\ =\frac{\$807+\$80+\$503}{\$80}\\ =\frac{\$1,390}{\$80}\\ =17.38\text{ times}\end{array}$

Hence, the times interest earned ratio 17.38 times.

Explanation of Solution

Times interest earned ratio

Times interest earnedratio quantifies the number of times the earnings before interest and taxes the business pay for the interest expense.  Use the following formula to calculate times-interest-earned ratio:

Formula:

$\begin{array}{l}\text{Times-interest-earned}\\ \text{ratio }\end{array}\}=\frac{\text{Net income}+\text{Income tax expense}+\text{Interest expense}}{\text{Interest expense}}$

(2)

To determine

To assess: Corporation BB’s liquidity and solvency relative to its industry.

Answer to Problem 3.17E

Comparison of corporation BB’s liquidity and solvency relative to its industry

• Current ratio is higher than the industry average.
• Acid test ratio is also higher than the industry average.
• Debt to equity ratio is significantly higher than the industry average because company assets are primarily financed with liabilities instead of equity.
• Times interest earned ratio is also significantly higher than the industry average.

Corporation BB’s seems to be little capable of meeting the interest obligations on its debt.

Explanation of Solution

Liquidity ratio

Liquidity ratio measures the short-term capacity of a company to pay its maturing obligations and to meet unanticipated requirements for cash. Liquidity ratios are current ratio, working capital ratio, acid test ratio and more.

Solvency ratio

Solvency ratio measures the capacity of a company to sustain over a long period of time. Solvency ratios are debt to assets ratio, time interest earned ratio, and debt to equity ratio, and more.