Problem 23 - Accounting

Question

Urban-Wear Clothes Co. had the following current assets and liabilities for two comparative years: \begin{tabular}{lrr} & Dec. 31, 2008 & Dec. 31, 2007 \\ \hline Current assets: & & \\ Cash & \(\$ 140,000\) & \(\$ 205,000\) \\ Accounts receivable & 250,000 & 245,000 \\ Inventory & 300,000 & 180,000 \\ \(\quad\) Total current assets & \(\$ 690,000\) & \(\$ 630,000\) \\ Current liabilities: & & \\ Current portion of long-term debt & \(\$ 50,000\) & \(\$ 50,000\) \\ Accounts payable & 200,000 & 190,000 \\ Accrued expenses payable & 140,000 & 135,000 \\ \(\quad\) Total current liabilities & \(\$ 390,000\) & \(\$ 375,000\) \\ \hline \end{tabular} a. Determine the quick ratio for December 31, 2008 and \(2007 .\) b. Interpret the change in the quick ratio between the two balance sheet dates.

Step-by-Step Solution

Answer

The quick ratio decreased from 1.2 in 2007 to 1.0 in 2008, indicating reduced liquidity.

Step 1: Understand Quick Ratio

The quick ratio, also known as the acid-test ratio, measures a company's ability to meet its short-term obligations using its most liquid assets. It is calculated as:\[\text{Quick Ratio} = \frac{\text{Cash + Accounts Receivable}}{\text{Current Liabilities}}\]This formula excludes inventory because it is not as liquid as cash or accounts receivable.

Step 2: Calculate Quick Ratio for 2008

For December 31, 2008, the values needed are:- Cash: \(140,000\)- Accounts Receivable: \(250,000\)- Current Liabilities: \(390,000\)Substitute these values into the formula:\[\text{Quick Ratio 2008} = \frac{140,000 + 250,000}{390,000}\]This simplifies to:\[\text{Quick Ratio 2008} = \frac{390,000}{390,000} = 1.0\]

Step 3: Calculate Quick Ratio for 2007

For December 31, 2007, the values needed are:- Cash: \(205,000\)- Accounts Receivable: \(245,000\)- Current Liabilities: \(375,000\)Substitute these values into the formula:\[\text{Quick Ratio 2007} = \frac{205,000 + 245,000}{375,000}\]This simplifies to:\[\text{Quick Ratio 2007} = \frac{450,000}{375,000} = 1.2\]

Step 4: Interpret the Change

The quick ratio decreased from 1.2 in 2007 to 1.0 in 2008. This indicates a decline in Urban-Wear Clothes Co.'s ability to meet its short-term obligations using its most liquid assets. A ratio of 1.0 means they just cover the liabilities with quick assets, whereas 1.2 previously may have provided a bit more cushion.

Key Concepts

Current Assets and Liabilities

Understanding the distinction between current assets and liabilities is fundamental in conducting a financial analysis. **Current assets** include cash and other resources that are expected to be converted into cash, sold, or consumed within a year.
These might include:

• Cash
• Accounts receivable
• Inventory

These components are crucial for daily operational functions as they ensure liquidity and help to maintain smooth operations. Meanwhile, **current liabilities** are obligations that a company needs to settle within a year. Common examples are:

• Current portion of long-term debt
• Accounts payable
• Accrued expenses payable

In our example with Urban-Wear Clothes Co., the figures for both assets and liabilities help measure the financial health over different fiscal years, contributing to broader financial perspectives.

Liquidity Ratios

**Liquidity ratios** are crucial indicators of a firm's capability to meet short-term obligations without having to access long-term funds. One specific measurement used widely is the quick ratio, also known as the acid-test ratio. This evaluates a company's short-term liquidity by determining if it can cover its current liabilities with its most liquid assets.

To calculate the quick ratio, use the formula:\[\text{Quick Ratio} = \frac{\text{Cash + Accounts Receivable}}{\text{Current Liabilities}}\]\
Note that this formula deliberately excludes inventory because it isn't as easily convertible to cash in the short term. A higher quick ratio typically signifies a more liquid financial standing, which is beneficial because it highlights the company's ability to handle immediate debts.
Conversely, a declining ratio, such as with Urban-Wear Clothes Co.'s drop from 1.2 to 1.0 between 2007 and 2008, implies tighter liquidity, leaving little or no room for unexpected financial obligations.

Financial Analysis

Conducting a **financial analysis** involves examining financial statements to understand a company's economic health. It provides insights into the efficiency of operations, liquidity, profitability, and growth. Evaluating key indicators like the quick ratio, one can assess short-term financial health and risk management. Examining Urban-Wear Clothes Co.'s quick ratio over two comparative years illustrates a practical case of financial analysis in action.

Analyzing changes in these ratios can illuminate changes in the company's financial stability. It reveals how quickly the company can respond to short-term financial obligations with available liquid assets. A trend like a falling quick ratio alerts analysts and stakeholders to potential concerns with meeting immediate liabilities. Hence, financial analysis is a powerful tool that provides decision-making insight regarding operational adjustments and strategic planning.