18E - Intermediate Accounting (Kieso)

Question

The comparative balance sheets of Madrasah Corporation at the beginning and end of the year 2017 appear below.

MADRASAH CORPORATION
BALANCE SHEETS
Assets	Dec 31, 2017	Jan 1, 2017	Inc./Dec.
Cash	\(20,000	\)13,000	\(7,000 Inc.
Accounts receivable	106,000	88,000	18,000 Inc.
Equipment	39,000	22,000	17,000 Inc.
Less: Accumulated depreciation – Equipment	17,000	11,000	6,000 Inc.
Total	\)148,000	\(112,000
Liabilities and Stockholder’s equity
Account payable	\)20,000	\(15,000	5,000 Inc.
Common stock	100,000	80,000	20,000 Inc.
Retained earnings	28,000	17,000	11,000 Inc.
Total	\)148,000	\(112,000

 

Net income of \)44,000 was reported, and dividends of $33,000 were paid in 2017. New equipment was purchased and none was sold.

Instructions 

(a) Prepare a statement of cash flows for the year 2017. 

(b) Compute the current ratio (current assets ÷ current liabilities) as of January 1, 2017, and December 31, 2017, and compute free cash flow for the year 2017. 

(c) In light of the analysis in (b), comment on Madrasah’s liquidity and financial flexibility.

Step-by-Step Solution

Answer

The current ratio of the company is 6.3 times.

Definition of Current Ratio

The financial metric used to evaluate the financial liquidity of the business entity by using the current assets and current liabilities is known as the current ratio.

$Current ratio = \frac{Current Assets}{Current Liabilities}$

Statement of cash flow

Particular	Amount $	Amount $
Cash flow from operations
Net income	$44,000
Add or less: Adjustments to net income
Depreciation expenses	6,000
Increase in accounts receivables	(18,000)
Increase in accounts payable	5,000
Cash flow from operating activities		$37,000
Cash flow from investing activities
Purchase of equipment	(17,000)
Cash flow used in investing activities		(17,000)
Cash flow from financing activities
Cash dividend	(33,000)
Issue of common stock	20,000
Cash flow used in financing activities		(13,000)
Net increase or decrease in cash		7,000
Add: opening cash balance		13,000
Ending cash balance		$20,000

Current ratio and Free Cash Flow

$\begin{array}{rcl}\mathrm{Current} \mathrm{Ratio}& =& \frac{\mathrm{Current} \mathrm{Assets}}{\mathrm{Current} \mathrm{Liabilities}}\\ & =& \frac{\$126,000}{\$20,000}\\ & =& 6.3 \mathrm{times}\end{array}$

Calculation of free cash flow:

Particular	Amount $
Cash flow from operations	$37,000
Less: Capital expenditure	(17,000)
Less: Cash dividend	(33,000)
Free cash flow	($13,000)

Interpreting Liquidity and Flexibility

Liquidity: The business entity reflects a good liquidity position because the current ratio is 6.3 times. It means that a business entity can easily pay off its current liabilities by using the current assets.

Flexibility: The business entity is not efficient in terms of financial flexibility because free cash flow is negative. The business entity cannot cover its capital expenditure and dividend expenses using the cash generated from the basic functions.