Chapter 8, Problem 8.2APFA

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 A for the past two year is as follows:

In 2012:

$\begin{array}{c}\text{Current ratio}=\frac{\text{Current assets}}{\text{Current}\text{liabilities}}\\ =\frac{\$1,287,488}{\$405,401}\\ =3.18\text{ times}\end{array}$

In 2013:

$\begin{array}{c}\text{Current ratio}=\frac{\text{Current assets}}{\text{Current}\text{liabilities}}\\ =\frac{\$1,141,800}{\$435,902}\\ =2.62\text{ times}\end{array}$

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 A for the past two year is as follows:

In 2012:

$\begin{array}{c}\text{Acid-test ratio}=\frac{\left(\begin{array}{l}\text{Cash}+\text{Short-term investments}\\ +\text{Accounts receivable}\end{array}\right)}{\text{Current liabilities}}\\ =\frac{\left(\begin{array}{l}\$719,545+\$25,499+\\ \$40,310\end{array}\right)}{\$405,401}\\ =1.94\text{times}\end{array}$

In 2013:

$\begin{array}{c}\text{Acid-test ratio}=\frac{\left(\begin{array}{l}\text{Cash}+\text{Short-term investments}\\ +\text{Accounts receivable}\end{array}\right)}{\text{Current liabilities}}\\ =\frac{\left(\begin{array}{l}\$509,119+\$121,873\\ +\$46,321\end{array}\right)}{\$435,902}\\ =1.55\text{times}\end{array}$

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 A used $100 million in cash to pay $100 million in accounts payable.

Explanation of Solution

Calculate current ratio if company used $100 million in current investments to pay $100 million in current accounts payable.

If the company used $100 million in current investments to pay $100 million in current accounts payable, the current assets and the current liabilities both decreases by $100 million. Thus, this transaction increases the current ratio. The calculation is as given below:

Before:

$\begin{array}{c}\text{Current ratio}=\frac{\text{Current assets}}{\text{Current}\text{liabilities}}\\ =\frac{\$1,141,800}{\$435,902}\\ =2.62\text{ times}\end{array}$

After:

$\begin{array}{c}\text{Current ratio}=\frac{\text{Current assets}}{\text{Current}\text{liabilities}}\\ =\frac{\$1,141,800-\$100,000,000}{\$435,902-\$100,000,000}\\ =3.10\text{ times}\end{array}$

Calculate acid-test ratio if company used $100 million in current investments to pay $100 million in current accounts payable.

If the company used $100 million in current investments to pay $100 million in current accounts payable, the quick assets and the current liabilities both decreases by $100 million. Thus, this transaction increases the acid-test ratio. The calculation is as given below:

Before:

$\begin{array}{c}\text{Acid-test ratio}=\frac{\left(\begin{array}{l}\text{Cash}+\text{Short-term investments}\\ +\text{Accounts receivable}\end{array}\right)}{\text{Current liabilities}}\\ =\frac{\left(\$509,119+\$121,873+\$46,321\right)}{\$435,902}\\ =1.55\text{times}\end{array}$

After:

$\begin{array}{c}\text{Acid-test ratio}=\frac{\left(\begin{array}{l}\text{Cash}+\text{Short-term investments}\\ +\text{Accounts receivable}\end{array}\right)}{\text{Current liabilities}}\\ =\frac{\left(\begin{array}{l}\$509,119+\$121,873\\ +\$46,321\end{array}\right)-\$100,000,000}{\$435,902\text{t }-\$100,000,000}\\ =1.72\text{times}\end{array}$

$\begin{array}{c}\text{Acid-test ratio}=\frac{\left(\begin{array}{l}\text{Cash}+\text{Short-term investments}\\ +\text{Accounts receivable}\end{array}\right)}{\text{Current liabilities}}\\ =\frac{\left(\begin{array}{l}\$719,545+\$25,499+\\ \$40,310\end{array}\right)}{\$405,401\text{thousand}}\\ =1.94\text{times}\end{array}$

Conclusion

Therefore, both current and acid test ratio is increased.