Problem 6 - Accounting

Question

The following data were taken from the balance sheet of Marine Equipment Company: \begin{tabular}{lrr} & Dec. 31, 2006 & Dec. 31, 2005 \\ \hline Cash & \(\$ 118,000\) & \(\$ 95,000\) \\ Marketable securities & 152,000 & 131,000 \\ Accounts and notes receivable (net) & 210,000 & 198,000 \\ Inventories & 345,000 & 326,000 \\ Prepaid expenses & 50,000 & 45,000 \\ Accounts and notes payable (short-term) & 190,000 & 208,000 \\ Accrued liabilities & 60,000 & 57,000 \end{tabular} a. Determine for each year (1) the working capital, (2) the current ratio, and (3) the quick ratio. b. What conclusions can be drawn from these data as to the company's ability to meet its currently maturing debts?

Step-by-Step Solution

Answer

The company's liquidity improved from 2005 to 2006, as evidenced by higher working capital, current ratio, and quick ratio.

Step 1: Calculate Current Assets for 2005 and 2006

For each year, the current assets include cash, marketable securities, accounts and notes receivable, inventories, and prepaid expenses.For 2005:\[ \text{Current Assets}_{2005} = \\(95,000 + \\)131,000 + \\(198,000 + \\)326,000 + \\(45,000 = \\)795,000 \]For 2006:\[ \text{Current Assets}_{2006} = \\(118,000 + \\)152,000 + \\(210,000 + \\)345,000 + \\(50,000 = \\)875,000 \]

Step 2: Calculate Current Liabilities for 2005 and 2006

Current liabilities include accounts and notes payable and accrued liabilities. For 2005:\[ \text{Current Liabilities}_{2005} = \\(208,000 + \\)57,000 = \\(265,000 \]For 2006:\[ \text{Current Liabilities}_{2006} = \\)190,000 + \\(60,000 = \\)250,000 \]

Step 3: Calculate Working Capital for 2005 and 2006

Working capital is the difference between current assets and current liabilities.For 2005:\[ \text{Working Capital}_{2005} = \\(795,000 - \\)265,000 = \\(530,000 \]For 2006:\[ \text{Working Capital}_{2006} = \\)875,000 - \\(250,000 = \\)625,000 \]

Step 4: Calculate Current Ratio for 2005 and 2006

The current ratio is the ratio of current assets to current liabilities.For 2005:\[ \text{Current Ratio}_{2005} = \frac{\\(795,000}{\\)265,000} \approx 3.00 \]For 2006:\[ \text{Current Ratio}_{2006} = \frac{\\(875,000}{\\)250,000} = 3.50 \]

Step 5: Calculate Quick Assets for 2005 and 2006

Quick assets are current assets minus inventories and prepaid expenses.For 2005:\[ \text{Quick Assets}_{2005} = \\(95,000 + \\)131,000 + \\(198,000 = \\)424,000 \]For 2006:\[ \text{Quick Assets}_{2006} = \\(118,000 + \\)152,000 + \\(210,000 = \\)480,000 \]

Step 6: Calculate Quick Ratio for 2005 and 2006

The quick ratio, or acid-test ratio, is the ratio of quick assets to current liabilities.For 2005:\[ \text{Quick Ratio}_{2005} = \frac{\\(424,000}{\\)265,000} \approx 1.60 \]For 2006:\[ \text{Quick Ratio}_{2006} = \frac{\\(480,000}{\\)250,000} = 1.92 \]

Step 7: Conclusion on the Company's Ability to Meet Debts

The increase in both working capital and current ratio from 2005 to 2006 indicates an improvement in the company's liquidity position. Additionally, the quick ratio has also increased, suggesting that the company is better equipped to meet its short-term liabilities with its most liquid assets as of 2006.

Key Concepts

Understanding Working Capital

Working capital is a vital measure in financial analysis that allows businesses to understand their short-term financial health. It represents the difference between a company's current assets and current liabilities. Here's why working capital matters:

• It demonstrates the company's capability to fund its day-to-day operations.
• Positive working capital generally indicates that a company can pay off its short-term liabilities easily with its short-term assets.

To calculate working capital, you subtract current liabilities from current assets. For example, in 2005, Marine Equipment Company had current assets totaling $795,000 and current liabilities of $265,000. Hence, the working capital amounted to $530,000. Similarly, for 2006, the working capital increased to $625,000, reflecting an increase in liquidity.
Consistently positive working capital suggests a stable financial footing, while negative working capital might signal potential financial trouble. This is crucial for investors since it indicates whether the company is financially robust enough to handle short-term challenges.

Exploring the Current Ratio

The current ratio is a popular liquidity ratio used to assess a company's ability to cover its short-term obligations with its short-term assets. To find this ratio, you divide current assets by current liabilities. A higher current ratio indicates a better position to pay off short-term debts.
In the case of Marine Equipment Company, the current ratio for 2005 was approximately 3.00, calculated by dividing $795,000 (current assets) by $265,000 (current liabilities). For 2006, this ratio increased to 3.50, exhibiting an improved liquidity position.

• A current ratio of more than 1.0 usually suggests that a company has more assets than liabilities, signifying financial health.
• However, a very high current ratio might also imply excessive inventory or accounts receivable, which could tie up capital unproductively. Hence, balanced analysis is key.

Investors and analysts often examine this ratio over time to understand how a company’s financial stability is evolving in the short term.

Decoding the Quick Ratio

The quick ratio, or acid-test ratio, is a stricter measure of liquidity compared to the current ratio. It excludes inventories and prepaid expenses from current assets before comparing them to current liabilities. By doing so, it focuses only on the most liquid assets, assuming inventories may not be as quickly converted to cash.
The quick ratio formula is: Quick Assets divided by Current Liabilities. For the Marine Equipment Company, the quick ratio was approximately 1.60 in 2005 and improved to 1.92 in 2006. This means they could cover their current liabilities 1.92 times over with their most liquid assets as of 2006.

• A quick ratio of less than 1.0 might indicate potential liquidity problems, as the company cannot cover its liabilities with its liquid assets alone.
• A higher quick ratio provides reassurance that the company can meet its obligations without needing to sell inventory.

A company with a strong quick ratio is often seen by investors as having solid liquidity, offering a good cushion against economic downturns.