Q19E - Horngren'S Financial And Managerial Accounting

Question

Big Beautiful Photo Shop has asked you to determine whether the company’s ability to pay current liabilities and total liabilities improved or deteriorated during 2018. To answer this question, you gather the following data:

	2018	2017
Cash	\(58,000	\)47,000
Short-term Investments	34,000	0
Net Accounts Receivable	140,000	124,000
Merchandise Inventory	217,000	272,000
Total Assets	530,000	565,000
Total Current Liabilities	288,000	205,000
Long-term Notes Payable	40,000	50,000
Income from Operations	165,000	158,000
Interest Expense	55,000	41,000

 

Compute the following ratios for 2018 and 2017, and evaluate the company’s ability to pay its current liabilities and total liabilities: 

a. Current ratio 

b. Cash ratio 

c. Acid-test ratio 

d. Debt ratio 

e. Debt to equity ratio

Step-by-Step Solution

Answer

S.no.	Ratios	2018	2017
a	Current ratio	1.56	2.16
b	Cash ratio	0.20	0.23
c	Acid-test ratio	0.81	0.83
d	Debt ratio	61.9%	45.1%
e	Debt to equity ratio	1.62	0.82

 

Step 1: Meaning of Ratio Analysis

Financial data points from a company's financial statements are used in ratio analysis to assess several factors, including profitability, liquidity, and solvency.

Step 2: (1) Computing current ratio

2018

$\begin{array}{c}\text{Current\hspace{0.33em}ratio}=\frac{\text{Total\hspace{0.33em}current\hspace{0.33em}asset}}{\text{Total\hspace{0.33em}current\hspace{0.33em}liabilities}}\\ =\frac{\$58,000+\$34,000+\$140,000+\$217,000}{\$288,000}\\ =\frac{\$449,000}{\$288,000}\\ =1.56\end{array}$ 

2017

 $\begin{array}{c}\text{Current\hspace{0.33em}ratio}=\frac{\text{Total\hspace{0.33em}current\hspace{0.33em}asset}}{\text{Total\hspace{0.33em}current\hspace{0.33em}liabilities}}\\ =\frac{\$47,000+\$124,000+\$272,000}{\$205,000}\\ =\frac{\$443,000}{\$205,000}\\ =2.16\end{array}$

Step 3: (2) Computing cash ratio

2018

 $\begin{array}{c}\text{Cash\hspace{0.33em}ratio}=\frac{\text{Cash}+\text{Cash\hspace{0.33em}equivalent}}{\text{Total\hspace{0.33em}current\hspace{0.33em}liabilities}}\\ =\frac{\$58,000+\$0}{\$288,000}\\ =0.20\end{array}$

2017

 $\begin{array}{c}\text{Cash\hspace{0.33em}ratio}=\frac{\text{Cash}+\text{Cash\hspace{0.33em}equivalent}}{\text{Total\hspace{0.33em}current\hspace{0.33em}liabilities}}\\ =\frac{\$47,000+\$0}{\$205,000}\\ =0.23\end{array}$

Step 4: (3) Computing acid-test ratio

2018

$\begin{array}{c}\text{Acid-test\hspace{0.33em}ratio}=\frac{\text{Cash}+\text{Short-term\hspace{0.33em}investment}+\text{Net\hspace{0.17em}current\hspace{0.33em}receivables}}{\text{Total\hspace{0.33em}current\hspace{0.33em}liabilities}}\\ =\frac{\$58,000+\$34,000+\$140,000}{\$288,000}\\ =0.81\end{array}$ 

2017

 $\begin{array}{c}\text{Acid-test\hspace{0.33em}ratio}=\frac{\text{Cash}+\text{Short-term\hspace{0.33em}investment}+\text{Net\hspace{0.17em}current\hspace{0.33em}receivables}}{\text{Total\hspace{0.33em}current\hspace{0.33em}liabilities}}\\ =\frac{\$47,000+\$0+\$124,000}{\$205,000}\\ =0.83\end{array}$

Step 5: (4) Computing debt ratio

2018

 $\begin{array}{c}\text{Debt\hspace{0.33em}ratio}=\frac{\text{Total\hspace{0.33em}liabilities}}{\text{Total\hspace{0.33em}assets}}\\ =\frac{\$288,000+\$40,000}{\$530,000}\\ =61.9\%\end{array}$

2017

 $\begin{array}{c}\text{Debt\hspace{0.33em}ratio}=\frac{\text{Total\hspace{0.33em}liabilities}}{\text{Total\hspace{0.33em}assets}}\\ =\frac{\$205,000+\$50,000}{\$565,000}\\ =45.1\%\end{array}$

Step 6: (5) Computing debt to equity ratio

2018

 $\begin{array}{c}\text{Debt\hspace{0.33em}to\hspace{0.33em}equity\hspace{0.33em}ratio}=\frac{\text{Total\hspace{0.33em}liabilities}}{\text{Total\hspace{0.33em}equity}}\\ =\frac{\$288,000+\$40,000}{\$530,000-\$328,000}\\ =1.62\end{array}$

2017

 

 $\begin{array}{c}\text{Debt\hspace{0.33em}to\hspace{0.33em}equity\hspace{0.33em}ratio}=\frac{\text{Total\hspace{0.33em}liabilities}}{\text{Total\hspace{0.33em}equity}}\\ =\frac{\$205,000+\$50,000}{\$565,000-\$255,000}\\ =\frac{\$255,000}{\$310,000}\\ =0.82\end{array}$

Step 7: Analysis of the ratio

The corporation appears to have the liquidity to satisfy these obligations because the current ratio and quick ratio are both very high. The corporation is not overly indebted because both the debt-to-equity ratio and the debt ratio are at ordinary levels. All ratios declined in 2018 compared to 2017, which decreased the company's capacity to pay short-term and long-term obligations.