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 2015:

Here,

Current assets = $324,589 thousand

Current liabilities = $122,271 thousand

$\begin{array}{c}\text{Current ratio}=\frac{\text{Current assets}}{\text{Current}\text{liabilities}}\\ =\frac{\$324,589\text{thousand}}{\$122,271\text{thousand}}\\ =2.66\text{ times}\end{array}$

In 2014:

Current assets = $342,137 thousand

Current liabilities = $132,381 thousand

$\begin{array}{c}\text{Current ratio}=\frac{\text{Current assets}}{\text{Current}\text{liabilities}}\\ =\frac{\$342,137\text{thousand}}{\$123,381\text{thousand}}\\ =\text{2}\text{.77 times}\end{array}$

Conclusion

Therefore, the current ratio in the most recent year (2015) 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 2015:

Here,

Cash= $133,708 thousand

Accounts receivable = $8,567 thousand

Short-term investment= $25,857 thousand

Current liabilities = $122,271 thousand

$\begin{array}{c}\text{Acid-test ratio}=\frac{\left(\begin{array}{l}\text{Cash}+\text{Short-term investments}\\ +\text{Accounts receivable}\end{array}\right)}{\text{Current liabilities}}\\ =\frac{\left(\begin{array}{l}\$133,708\text{thousand}+\$25,857thousand+\\ \$8,567\text{thousand}\end{array}\right)}{\$122,271\text{thousand}}\\ =1.38\text{times}\end{array}$

In 2014:

Here,

Cash= $164,868 thousand

Accounts receivable = $4,318 thousand

Short-term investment= $20,197 thousand

Current liabilities = $123,381 thousand

$\begin{array}{c}\text{Acid-test ratio}=\frac{\left(\begin{array}{l}\text{Cash}+\text{Short-term investments}\\ +\text{Accounts receivable}\end{array}\right)}{\text{Current liabilities}}\\ =\frac{\left(\begin{array}{l}\$164,868\text{thousand}+\$20,197thousand\\ +\$4,318\text{thousand}\end{array}\right)}{\$123,381\text{thousand}}\\ =1.53\text{times}\end{array}$

Conclusion

Therefore, the acid test ratio in the most recent year (2015) 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:

$\begin{array}{c}\text{Current Ratio}=\frac{\text{Current assets}}{\text{Current}\text{liabilities}}\\ =\frac{\$324,589,\text{000}+\text{\$50,000,000}}{\$122,271,000+\text{\$50,000,000}}\\ =\text{2}\text{.18 times}\end{array}$

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:

$\begin{array}{c}\text{Acid-test ratio}=\frac{\left(\begin{array}{l}\text{Cash}+\text{Short-term investments}\\ +\text{Accounts receivable}\end{array}\right)}{\text{Current liabilities}}\\ =\frac{\left(\begin{array}{l}\$133,708,000+\$25,857,000+\\ \$8,567,000+\$50,000,000\end{array}\right)}{\$122,271,000+\$50,000,000}\\ =1.27\text{times}\end{array}$

Conclusion

Therefore, both current and acid test ratio is decreased.