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Chapter 6
Liquidity of Short-term Assets:
Related Debt-Paying Ability
QUESTIONS
6- 1. In the very short run, the procedure of making more funds available by slowing
creditors would demand payment and they may refuse to sell to our firm or
opposite of what was intended.
6- 2. When a firm is growing fast, it needs a large amount of funds to expand its
inventory and receivables. At the same time, payroll and payables require
credit terms received on the payables.
assets in order to expand capacity.
Fast-growing firms typically do have a problem with a shortage of funds. It is
and possible bankruptcy.
6- 3. Current assets are assets that are in the form of cash or that will be realized in
The other assets are not expected to be realized in cash in the near future and
should, therefore, be segregated from current assets.
6- 4. The operating cycle is the period of time elapsing between the acquisition of
collections.
6- 5. Current assets are assets that are in the form of cash or that will be realized in
6- 6. The five major categories of items that are found in current assets are the
following:
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6- 7. The cash frozen in a bank in Cuba should not be classified as a current asset
6- 8. This guaranteed note would not be recorded by A.B. Smith Company;
disclosed in a footnote to the financial statements.
6- 9. This investment would not be classified as a marketable security because
6-10. a. Number of days’ sales in receivables
6-12. A company that uses a natural business year would tend to overstate the
liquidity of its receivables. The two computations that are made to indicate the
receivables during the year. The accounts receivable turnover would be high,
based on the natural business year in relation to the turnover and the
receivables figures during the year.
6-13. Since the receivables will be at their peak at the end of the year, the days’
the peak of its business.
6-14. This distortion can be eliminated by using the average monthly receivables
6-15. The liquidity of the receivables will be overstated if the sales figure includes
meaningful.
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6-16. Inventories of a retail company are usually classified in one inventory account
inventory in production, work in process inventory; and inventory completed –
finished goods inventory.
6-17. The most realistic valuation of inventory would be the FIFO method because
in inventory.
6-18. a. If the company uses a natural business year for its accounting period,
the number of days’ sales in inventory will tend to be understated. When
sales in inventory than actually exists.
b. If the company closes the year when the activities are at a peak, the
c. If the company uses LIFO inventory, the number of days’ sales in
be at higher current cost.
6-19. a. There is no ideal number of days’ sales in inventory. The number that a
company should have would be guided by company policy and industry
averages.
c. Days’ sales in inventory can be too low, resulting in lost sales, limited
production runs, higher transportation costs, etc.
6-20. When the cost of goods sold is not available to compute days’ sales in
using net sales.
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6-21. The distortions from seasonal fluctuations or the use of a natural business
6-22. When prices are rising, the use of LIFO inventory will result in a much higher
6-24. Current liabilities are obligations whose liquidation is reasonably expected to
6-25. (1) a. Working capital
The excess of current assets over current liabilities.
b. Current ratio
c. Acid-test ratio
d. Cash ratio
total current liabilities.
(2) a. Working capital
Working capital based on cost figures will tend to be understated
because inventory will be stated at amounts that do not represent
current value.
b. Current ratio
c. Acid-test ratio
The acid-test ratio will tend to be accurate.
d. Cash ratio
(3) To avoid the understatements in working capital and the current ratio,
use the replacement (current) cost of inventory when it is disclosed.
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6-26. The current working capital amount should be compared with past working
another firm will usually be meaningless because of the different sizes of the
firms.
6-27. The current ratio is considered to be more indicative of the short-term debt-
difference between the current assets and the current liabilities.
6-28. The acid-test ratio is considered to be a better guide to short-term liquidity
the inventory has been pledged, or the inventory is held for a long period of
has a long collection period for receivables.
6-29. If a firm can reduce its operating cycle, it can benefit from having more funds
available for operating or it could reduce the funds that it uses in operations.
with the improved operating cycle without expanding plant and equipment.
This expansion in sales could also mean greater profits. Opportunities to
and the accounts receivable.
6-30. Some industries naturally need a longer operating cycle than others because
receivables from the sales than it does for the food store to buy its inventory
6-31. Because funds to operate the business are costly to the firm, a firm with a
longer operating cycle usually charges a high mark-up on its inventory cost
have a higher mark-up.
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due to competitive forces in price.
6-32. Profitability is often not of major importance in determining the short-term debt-
period.
6-33. The use of the allowance for doubtful accounts approach results in the bad
asset.
6-34. This is true because the most recent purchases end up in cost of goods sold
on the income statement.
6-35. This type of a current asset would not be a normal recurring current asset.
6-36. Accounts receivable and inventory are often major segments of current assets.
inventory. Poor quality in receivables and/or inventory will increase the current
6-37. Receivables can have a material influence on the acid-test ratio. Accounts
6-39. Under inflationary conditions the cash flow under LIFO is greater than the cash
between the alternative cost methods.
6-40. No, a low sales-to-working capital ratio is an indication of an unprofitable use
for each dollar of working capital.
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6-41. (1) Unused bank credit lines
6-42. There are many situations where the liquidity position of the firm may not be
as good as that indicated by the liquidity ratios. Some of the situations are the
following:
firm
(5) A major portion of the receivables are uncollectible
6-43. The sales-to-working capital ratio gives an indication of whether working
leaving old costs (lower) in inventory.
6-45. FIFO inventory – reported profit
Reported profit under LIFO
Increase in ending inventory
Reported profit under FIFO
Reported profit under LIFO
Increase in ending inventory
Reported profit under average cost
$100,000
10,000
$110,000
$100,000
5,000
$105,000
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PROBLEMS
PROBLEM 6-1
Current Assets
=
Current Assets – Inventory
=
Acid-Test
Current Liabilities
Current Liabilities
Ratio
Current Assets
=
$1,000,000 – Inventory
=
2.0
$400,000
$400,000
Current Assets
=
$1,000,000
$1,000,000 – Inventory
=
$800,000
$1,000,000 – $800,000
=
Inventory
$200,000 = Inventory
Inventory Turnover
=
Cost of Sales
Inventory
Cost of Sales
=
3
Inventory
Cost of Sales
=
3
$200,000
PROBLEM 6-2
a.
Days’ sales in receivables
=
Gross Receivables
Net Sales/365
$220,385 + $11,180
=
71.62 days
$1,180,178/365
$240,360 + $12,300
=
41.92 days
$2,200,000/365
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b.
Accounts receivable turnover =
Net Sales
Average Gross Receivables
2011:
$1,180,178
4.87 times
per year
($240,360 + $12,300 + $220,385 + $11,180) / 2
2010:
$2,200,000
=
8.98 times
per year
($230,180 + $7,180 + $240,360 + $12,300) / 2
c. The Hawk Company receivables have been much less liquid in 2011 in comparison
with 2010. The days’ sales in receivables at the end of the year have increased
the Hawk Company credit terms.
PROBLEM 6-3
a.
Days’ sales in receivables
=
Gross Receivables
Net Sales/365
December 31, 2011:
$55,400 + $3,500
=
26.87 days
$800,000/365
July 31, 2011:
$90,150 + $4,100
=
43.55 days
$790,000/365
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b.
Accounts receivable turnover
=
Net Sales
Average Gross Receivables
December 31, 2011:
=
$800,000
($50,000 + $3,000 + $55,400 + $3,500)/2
14.30 times per year
July 31, 2011:
=
$790,000
($89,000 + $4,000 + $90,150 + $4,100)/2
8.44 times per year
comparing different dates.
PROBLEM 6-4
a.
Days’ sales in receivables
=
Gross Receivables
Net Sales/365
L. Solomon company
days’ sales in receivables
$110,000 + $8,000
=
23.93 days
$1,800,000/365
L. Konrath Company
days’ sales in receivables
$60,000 + $4,000
=
12.63 days
$1,850,000/365
has its receivables at a low point at the end of the year. This would make its
liquidity overstated at the end of the year.