Charles H.

Gibson Financial Reporting & Analysis Using Financial Accounting Information

Tutorial 5

Liquidity of Short-Term Assets; Related Debt-Paying Ability

Questions

1. It is proposed at stockholders’ meeting that the firm slow its rate of payments on accounts
payable in order to make more funds available for operations. It is contended that this
procedure will enable the firm to expand inventory, which will in turn enable the firm to
generate more sales. Comment on this proposal.
Slowing down the payment of payables makes more funds available for growth: purchasing
more inventories in order to generate more sales. This would work for a very short-term
horizon. But, it wouldn’t work long because the obligations towards creditors need to be
met. Terms of credit with suppliers may also change unfavorably if the firm maintains
slowing down the rate of payment: creditors may demand more cash payments or interest-
bearing payables…
2. Jones Wholesale Company has been one of the fastest growing wholesale firms in the United
States for the last five years in terms of sales and profits. The firm has maintained a current
ratio above the average for the wholesale industry. Mr. Jones has asked you to explain
possible reasons why the firm is having difficulty meeting its payroll and its accounts payable.
What would you tell Mr. Jones?
Fast-growing companies need funds to expand. The company has increased its inventories
and receivables. At the same time, payroll and payables require funds. A possible explanation
would be that the credit terms with suppliers are shorter that the time period needed to sell
inventories and collect cash from receivables. Moreover, to expand, the company may need
to use funds from operations to purchase long-term/ facility-sustaining assets.
Shortage of funds is a typical financial problem for growth firms.
3. Arrow Company has invested funds in a supplier to help ensure a steady supply of needed
materials. Would this investment be classified as a marketable security (current asset)?
Securities purchased for to maintain business relationships with key business partners don’t
fall within the category of short-term investments: management don’t have the intent to sell
them in the short term.
4. During times of inflation, which of the inventory costing methods listed below would give the
most realistic valuation of inventory? Which method would give the least realistic valuation
of inventory? Explain.
a. LIFO
b. Average
c. FIFO
FIFO gives a more realistic valuation of inventory: the latest purchases correspond to the
goods are on hand: closest value to market. Under LIFO, the goods on hand correspond to
the oldest purchases: the value would be far from market value. Note that the average
method gives an “intermediate” valuation or an average position between FIFO and LIFO
values.

5. In determining the short-term liquidity of a firm, the current ratio is usually considered to be
a better guide than the acid-test ratio, and the acid-test ratio is considered to be better guide
than the cash ratio. Discuss when the acid-test ratio would be preferred over the current
ratio and when the cash ratio would be preferred over the acid-test ratio.
The acid-test ratio would be preferred over the current ratio when there are liquidity
problems related to the inventories: slow-moving inventories, goods pledged to specific
creditors, use of LIFO under inflation and related valuation problems…

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Charles H. Gibson Financial Reporting & Analysis Using Financial Accounting Information

In case of receivables-related problems, the cash ratio would be preferred over the acid-test
ratio: long collection period.
6. Discuss some of the benefits that may accrue to the firm from reducing its operating cycle.
Suggest some of the ways that may be used to reduce a company’s operating cycle.
Reducing the operating cycle would make more funds available for operations or reduce the
funds used in operations. Profits would increase since the firm maintains the same level of
sales with less operating assets. The firm can also increase sales without expanding non-
current assets. Improving the operating cycle could be done through management of
inventories and receivables.

Problems

1 In this problem compute the acid-test ratio as follows:

Current Assets−Inventory
Current Liabilities
Required: Determine the cost of sales of a firm with the following financial data:

Current ratio 2.5

Acid-test ratio 2.0

Current liabilities $400 000

Inventory turnover 3 times

Cost of sales = $600 000

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Charles H. Gibson Financial Reporting & Analysis Using Financial Accounting Information

2 Hawk Company wants to determine the liquidity of its receivables. It has supplied you with the
following data regarding selected accounts for December 31, N, and N-1:

N N-1
Net sales $1 180 178 $2 200 000
Receivables, less allowance for losses and discounts
Beginning of year (allowance for losses and discounts, N_$12 300; 240 360 230 180
N-1_$7 180)
End of year (allowance for losses and discounts, N_$11 180; 220 385 240 360
N-1_$12 300)
Required:

a. Compute the number of days’ sales in receivables at December 31, N, and N-1.
b. Compute the accounts receivable turnover for N and N-1.
c. Comment on the liquidity of Hawk Company receivables.

N N-1
Days’ sales in receivables 71.62 days 41.92 days
Accounts receivable turnover 4.87 times per year 8.98 times per year
Major deterioration of receivables. Possible causes: customer concentration, difficulty in collecting
receivables, change in credit terms…

a. P. Gibson Company has computed its accounts receivable turnover in days to be 36.

Required: Compute the accounts receivable turnover per year. 10.14 times per year

b. P. Gibson Company has computed its accounts receivable turnover per year to be 12.

Required: Compute the accounts receivable turnover in days. 30.42 days

c. P. Gibson Company has gross receivables at the end of the year of $280 000 and net sales for
the year of $2 158 000.

Required: Compute the days’ sales in receivables at the end of the year. 47.36 days

d. P. Gibson Company has net sales of $3 500 000 and average gross receivables of $324 000.

Required: Compute the accounts receivable turnover. 10.8 times per year

4 D. Szabo Company had an average inventory of $280 000 and a cost of goods sold of $1 250 000.

Required: Compute the following:

a. The inventory turnover in days 81.76 days

b. The inventory turnover 4.46 times per year
5 The inventory and sales data for this year for G. Rabbit Company are as follows:

End of year Beginning of year

Net sales $3 150 000
Gross receivables 180 000 $160 000
Inventory 480 000 390 000
Cost of goods sold 2 250 000

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Charles H. Gibson Financial Reporting & Analysis Using Financial Accounting Information

Required: Using the above data from G. Rabbit Company, compute the following:

a. The accounts receivable turnover in days 19.70 days

b. The inventory turnover in days 70.57 days
c. The operating cycle 90.27 days
6 Anna Banana Company would like to know how long it will take to realize cash from its ending
inventory. For this purpose, the following data are submitted:

Accounts receivable, less allowance for doubtful accounts of $30 000 $560 000
Ending inventory 680 000
Net sales 4 350 000
Cost of goods sold 3 600 000
Required: Estimate how long it will take to realize cash from the ending inventory.

Time to realize cash from ending inventory= days sales in inventory + days sales in receivables=
68.94+49.51 = 118.45 days

7 A partial balance sheet and income statement for King Corporation follow:

KING CORPORATION

Partial balance sheet

December 31, N

Assets
Current assets
Cash $33 493
Marketable securities 215 147
Trade receivables, less allowance of $6 000 255 000
Inventories, LIFO 523 000
Prepaid expenses 26 180
Total current assets 1 052 820
Liabilities
Current liabilities
Trade accounts payable $103 689
Notes payable (primarily to banks) and commercial paper 210 381
Accrued expenses and other liabilities 120 602
Income taxes payable 3 120
Current maturities of long-term debt 22 050
Total current liabilities $459 842

KING CORPORATION

Partial income statement

For year ended December 31, N

Net sales $3 050 600

Miscellaneous income 45 060
3 095 660
Costs and expenses

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Charles H. Gibson Financial Reporting & Analysis Using Financial Accounting Information

Cost of sales $2 185 100

Selling, general and administrative expenses 350 265
Interest expense 45 600
Income taxes 300 000
2 880 965
Net income $214 695
Note: The trade receivables at December 31, N-1 were $280 000, net of an allowance of $8 000. The
inventory at December 31, N-1 was $565 000.

Required: Compute the following:

a. Working capital $592 978

b. Current ratio 2.29
c. Acid-test ratio 1.1
d. Cash ratio 0.54
e. Days’ sales in receivables 31.23 days
f. Accounts receivable turnover in days 32.84 days
g. Days’ sales in inventory 87.36 days
h. Inventory turnover in days 90.87 days
i. Operating cycle 123.71 days

8The following data relate to inventory for the year ended December 31, N. A physical inventory on
December 31, N indicates that 600 units are on hand and that they came from the July 1 purchase.

Date Description Number of units Cost per unit Total cost

January 1 Beginning inventory 1 000 $4.00 $4 000
February 20 Purchase 800 4.50 3 600
April 1 Purchase 900 4.75 4 275
July 1 Purchase 700 5.00 3 500
October 22 Purchase 500 4.90 2 450
December 10 Purchase 500 5.00 2 500
4 400 $20 325

Required: Compute the cost of goods sold for the year ended December 31, N and the ending
inventory under the following cost assumptions:

a. FIFO
b. LIFO
c. Average cost (weighted average)
d. Specific identification

FIFO LIFO Average cost Specific identification

Ending inventory ($) 2 990 2 400 2 772 3 000
COGS ($) 17 335 17 925 17 553 17 325
Note that the firm is using the periodic system: the cost of goods sold is determined at the end of the
period as the difference between the cost of goods available for sale and the value of the ending
inventory.