Chapter 8, Problem 8.3APFA

Requirement – 1

To determine

To calculate: The current ratio for the past two year, and discuss whether the current ratio improve or weaken in the most recent year.

Explanation of Solution

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 current ratio of Company B for the past two year is as follows:

In 2012:

$\begin{array}{c}\text{Current ratio}=\frac{\text{Current assets}}{\text{Current}\text{liabilities}}\\ =\frac{\$320,127}{\$109,831}\\ =2.91\text{ times}\end{array}$

In 2013:

$\begin{array}{c}\text{Current ratio}=\frac{\text{Current assets}}{\text{Current}\text{liabilities}}\\ =\frac{\$276,873}{\$128,9561}\\ =\text{2}\text{.15 times}\end{array}$

Conclusion

Therefore, the current ratio in the most recent year (2013) is weakened.

Requirement – 2

To determine

To calculate: The acid test ratio for the past two year, and discuss whether the acid test ratio improve or weaken in the most recent year.

Explanation of Solution

Acid-test Ratio:

It is a ratio used to determine a company’s ability to pay back its current liabilities by liquid assets that are current assets except inventory and prepaid expenses.

Formula:

$\text{Acid-test Ratio}=\frac{\text{Cash}+\text{Accounts Receivable}+\text{Short-term Investments}}{\text{Current Liabilities}}$

The acid test ratio of Company B for the past two year is as follows:

In 2012:

$\begin{array}{c}\text{Acid-test ratio}=\frac{\left(\begin{array}{l}\text{Cash}+\text{Short-term investments}\\ +\text{Accounts receivable}\end{array}\right)}{\text{Current liabilities}}\\ =\frac{\left(\begin{array}{l}\$166,511+\$29,998+\\ \$4,584\end{array}\right)}{\$109,831}\\ =1.83\text{times}\end{array}$

In 2013:

$\begin{array}{c}\text{Acid-test ratio}=\frac{\left(\begin{array}{l}\text{Cash}+\text{Short-term investments}\\ +\text{Accounts receivable}\end{array}\right)}{\text{Current liabilities}}\\ =\frac{\left(\begin{array}{l}\$117,608+\$26,414\\ +\$3,470\end{array}\right)}{\$128,956}\\ =1.14\text{times}\end{array}$

Conclusion

Therefore, the acid test ratio in the most recent year (2013) is weakened.

Requirement – 3

To determine

The manner in which the current ratio and acid test ratio will change, if Company B purchased $50 million of inventory by debiting inventory and crediting accounts payable.

Explanation of Solution

Calculate current ratio if company purchased $50 million of inventory by debiting inventory and crediting accounts payable.

If the company purchases $50 million of inventory, the current assets (inventory) and the current liabilities (accounts payable) both increase by $50 million. Thus, this transaction decreases the current ratio. The calculation is as given below:

Before:

$\begin{array}{c}\text{Current ratio}=\frac{\text{Current assets}}{\text{Current}\text{liabilities}}\\ =\frac{\$276,873}{\$128,9561}\\ =\text{2}\text{.15 times}\end{array}$

After:

$\begin{array}{c}\text{Current ratio}=\frac{\text{Current assets}}{\text{Current}\text{liabilities}}\\ =\frac{\$276,873+50}{\$128,9561+50}\\ =1.83\text{ times}\end{array}$

Calculate acid-test ratio if company purchased $50 million of inventory by debiting inventory and crediting accounts payable.

If the company purchases $50 million of inventory, the current liabilities increase by $50 million, but the quick assets remain same.  Hence, this transaction decreases the acid-test ratio. The calculation is as given below:

Before:

$\begin{array}{c}\text{Acid-test ratio}=\frac{\left(\begin{array}{l}\text{Cash}+\text{Short-term investments}\\ +\text{Accounts receivable}\end{array}\right)}{\text{Current liabilities}}\\ =\frac{\left(\begin{array}{l}\$117,608+\$26,414\\ +\$3,470\end{array}\right)}{\$128,956}\\ =1.14\text{times}\end{array}$

After:

$\begin{array}{c}\text{Acid-test ratio}=\frac{\left(\begin{array}{l}\text{Cash}+\text{Short-term investments}\\ +\text{Accounts receivable}\end{array}\right)}{\text{Current liabilities}}\\ =\frac{\left(\begin{array}{l}\$117,608+\$26,414\\ +\$3,470\end{array}\right)+50}{\$128,956+50}\\ =1.10\text{times}\end{array}$

Conclusion

Therefore, both current and acid test ratio is decreased.