FINC 350 Exam 3
2. List the two approaches to examining a firm's long-term debt-paying ability. Discuss why each of these approaches gives an important view of a firm's ability to carry debt.
(1) Income statement. (2) Balance sheet The income statement approach is important because, in the long run, there is usually a relationship between the reported income that is the result of accrual accounting and the ability of the firm to meet its long‑term obligations. The balance sheet indicates the amount of funds provided by outsiders in relation to those provided by owners of the firm. If a high proportion of the resources have been provided by outsiders, then this indicates that the risks of the business have been shifted to outsiders.
42. List three situations in which the liquidity position of the firm may be not as good as indicated by the liquidity ratios.
(1) Notes discounted in which the other party has full recourse against the firm (2) Guarantee of a bank note for another firm (3) Major pending lawsuits against the firm (4) A major portion of the inventory is obsolete (5) A major portion of the receivables are uncollectible
41. List three situations in which the liquidity position of the firm may be better than that indicated by the liquidity ratios.
(1) Unused bank credit lines (2) Long-term assets that have the potential to be converted to cash quickly (3) Capability to issue debt or stock
11. Differentiate between the types of inventory typically held by a retailing firm and a manufacturing firm.
5 -11. A manufacturing firm will have raw materials, work in process, finished goods, and supplies. A retail firm will only have merchandise inventories.
2. What does each of the following categories of ratios attempt to measure? Liquidity
5 ‑ 2. a. Liquidity is the ability to meet current obligations. Short‑term creditors such as banks or suppliers would be particularly interested in these ratios.
3. Brown Co earned 5.5% on sales in 2011. What further info would you need to evaluate this result?
5 ‑ 3. Comparisons of historical data, industry average, earnings of competitors, etc.
4. Differentiate between absolute and percentage changes. Which is generally a better measure of change? Why?
5 ‑ 4. An absolute change would be plus or minus X dollars; a percentage change would be plus or minus X percent of the base. Percentage changes usually give better measures because they recognize the difference in the size of the base.
6.What is trend analysis? Can it be used for ratios? For absolute figures?
5 ‑ 6. Trend analysis involves comparing the past to the present. It can be used both for ratios and absolute figures.
7. Suppose you are comparing two firms within an industry. One is large and the other is small. Will relative or absolute numbers be of more value in each case? What kinds of statistics can help evaluate relative size?
5 ‑ 7. When comparing two firms of different size, relative figures are most meaningful. These include ratios and common‑size analysis. The relative amounts of sales, assets, profits, or market share help evaluate relative size.
8. Are managers the only users of financial reports? Discuss.
5 ‑ 8. While managers make great use of financial reports, investors, creditors, employers, suppliers, regulators, auditors, and consumers also use financial reports.
9. Briefly describe how each of these groups might use financial reports: Managers: Investors: Creditors:
5 ‑ 9. Managers analyze data to study profitability, evaluate how efficiently they use their assets to generate revenues, and the overall financial position of the firm. Investors study profitability and the chance to earn on their investment. Creditors study the ability of the firm to handle debt.
12. Sometimes mfg firms have only raw materials and finished goods listed on their balance sheets. This is true of Avon Products, a manufacturer of cosmetics, and it might be true of food canners also. Explain the absence of WIP.
5 ‑12. Some types of products must be processed and immediately packaged for sale. They cannot be held in the processing state. Each night, all raw materials must be converted to finished goods. Cosmetics, such as nail polish, would dry up overnight. Foods might spoil. They, therefore, cannot be left in a semi-finished state.
1.It is proposed at a stockholder's meeting that the firm slow its rate of payments on accounts payable in order to make some more funds available for operations. It is contended that this procedurewill enable the firm to expand inventory, which will in turn enable the firm to generate more sales. Comment on this proposal.
6- 1. In the very short run, the procedure of making more funds available by slowing the rate of payments on accounts payable would work and the firm would have more funds to purchase inventory, which would in turn enable the firm to generate more sales. This procedure would not work very long because creditors would demand payment and they may refuse to sell to our firm or demand cash upon delivery. In either case, the end result would be the opposite of what was intended.
2. Jones Wholesale company has been one of the fastest growing wholesale firms in the US for the last five years in terms of sales and profits. The firm has maintained a current ratio above the average for the wholesale industry. Mr. Jones has asked you to explain possible reasons why the firm is having difficulty meeting its payroll and its accounts payable. What would you tell Mr. Jones?
6- 1. In the very short run, the procedure of making more funds available by slowing the rate of payments on accounts payable would work and the firm would have more funds to purchase inventory, which would in turn enable the firm to generate more sales. This procedure would not work very long because creditors would demand payment and they may refuse to sell to our firm or demand cash upon delivery. In either case, the end result would be the opposite of what was intended.
26. Discuss how to use working capital in analysis
6-26. The current working capital amount should be compared with past working capital amounts to determine if working capital is reasonable. Caution must be exercised because the relative size of the firm may be expanding or contracting. Comparing working capital of one firm with working capital of another firm will usually be meaningless because of the different sizes of the firms.
27. Both current assets and current liabilities are used in the computation of working capital and the current ratio, yet the current ratio is considered to be more indicative of the short-term debt-paying ability. Explain.
6-27. The current ratio is considered to be more indicative of the short-term debt-paying ability than the working capital because the current ratio takes into account the relative relation between the size of the current assets and the size of the current liabilities. Working capital only determines the absolute difference between the current assets and the current liabilities.
28. In determining the short-term liquidity of a firm, the current ratio is usually considered to be a better guide than the acid-test ratio, and the acid-test ratio is considered to be a better guide than the cash ratio. Discuss when the acid-test ratio would be preferred over the current ratio and when the cash ratio would be preferred over the acid-test ratio
6-28. The acid-test ratio is considered to be a better guide to short-term liquidity than the current ratio when there are problems with the short-run liquidity of inventory. Some problems with inventory could be in determining a reasonable dollar amount in relation to the quantity on hand (LIFO inventory), the inventory has been pledged, or the inventory is held for a long period of time. The cash ratio would be preferred over the acid-test ratio when there is a problem with the liquidity of receivables. An example would be an entity that has a long collection period for receivables.
29. Discuss some benefits that may accrue to a firm from reducing its operating cycle. Suggest some ways that may be used to reduce a company's operating cycle.
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. Since funds cost the firm money, it can increase profits by operating at a more efficient operating cycle. An improved operating cycle will enable the firm to operate with less plant and equipment and still maintain the present level of sales, thereby increasing profits. Or, the firm could expand the level of sales with the improved operating cycle without expanding plant and equipment. This expansion in sales could also mean greater profits. Opportunities to improve the operating cycle will be found in the management of the inventory and the accounts receivable.
30. Discuss why some firms have longer natural operating cycles than other firms
6-30. Some industries naturally need a longer operating cycle than others because of the nature of the industry. For example, we could not expect the car manufacturer to have an operating cycle that compares with that of a food store because it takes much longer to manufacture cars and collect the receivables from the sales than it does for the food store to buy its inventory and sell it for cash. Thus, comparing the operating cycles of a car manufacturer and a food store would not be a fair comparison.
31. would a firm with a relatively long operating cycle tend to charge a higher markup on its inventory cost than a firm with a short operating cycle? Discuss.
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 when selling than does a firm with a short operating cycle. This enables the firm to recover the cost for the funds that are used to operate the business. A food store usually has a very low mark-up, while a car manufacturer would have a higher mark-up.
32. Is the profitability of the entity considered to be of major importance in determining the short-term debt-paying ability? Discuss.
6-32. Profitability is often not of major importance in determining the short-term debt-paying ability of a firm. One of the reasons for this is that many revenue items and many expense items do not directly affect cash flow during the same period.
33. Does the allowance method for bad debts or the direct write-off method result in the fairest presentation of receivables on the balance sheet and the fairest matching of expenses against revenue?
6-33. The use of the allowance for doubtful accounts approach results in the bad debt expense being charged to the period of sale, thus matching this expense in the period of sale. It also results in the recognition of the impairment of the asset.
31. Speculate on why the disclosure of the concentrations of credit risk is potentially important to the used of financial reports.
7-31 Concentration of credit risk (lack of diversification) is perceived as indicative of greater credit risk. Disclosure in this area allows investors, creditors, and other users to make their own assessments of credit risk related to concentration.
32. Comment on the significance of disclosing the off balance-sheet risk of accounting loss.
7-32. Off-balance-sheet means that the risk has not been recorded. There is a potential accounting loss from these obligations that is not apparent from the face of the balance sheet.
33. Comment on the significance of disclosing the fair value of financial instruments.
7-33. The disclosure of the fair value of financial instruments could possibly indicate significant opportunity or additional risk to the company.
4. Would you expect an auto manufacturer to finance a relatively high proportion of its long-term funds from debt? Discuss.
7‑ 4. No. The auto manufacturing business is known for its cyclical nature. The times interest expense, therefore, would fluctuate materially. We would expect the auto manufacturer to finance a relatively small proportion of its long‑term funds from debt.
5. Would you expect a telephone company to have a high debt ratio? Discuss.
7‑ 5. A telephone company has its rate of return and, therefore, profits controlled by public utility commissions. We would expect the times interest earned to be moderate and relatively stable, which should be a relatively favorable times interest earned ratio. This stability allows for carrying a high portion of debt financing.
6. why should capitalized interest be added to interest expense when computing times interest earned?
7‑ 6. A firm must pay for the interest capitalized; therefore, this interest should be included along with interest expense in order to obtain total interest.
7. Discuss how noncash charges for depreciation, depletion, and amortization can be used to obtain a short-run view of times interest earned.
7‑ 7. To get a better indication of a firm's ability to cover interest payments in the short run, the non‑cash charges for depreciation, depletion, and amortization can be added back to the times interest earned numerator. The resulting income can be related to interest earned on a cash basis for a short‑run indication of the firm's ability to cover interest.
8. Why is it difficult to determine the value of assets?
7‑ 8. The financial statements are predominately prepared based upon historical cost. Seldom is the market value or liquidation value disclosed.
9. Is it feasible to get a precise measurement of the funds that could be available from long-term assets to pay long-term debt? Discuss.
7‑ 9. No, the determination of the current value of the long‑term assets is very subjective. The best that can be achieved is a reasonable relationship of long‑term assets to long‑term debt, based on historical cost or estimates of current value (appraisals of the assets by third parties).
10.One of the ratios used to indicate long-term debt-paying ability compares total liabilities to total assets. What is the intent of this ratio? How precise is this ratio in achieving its intent?
7‑10. The intent of this ratio is to indicate the percentage of the assets that were financed by creditors. The ratio should indicate a reasonably accurate picture of how the assets were financed, but it will not be precise because all of the liabilities have been included, while the assets are at book value, which may be less than or more than their liquidation value.
11. For a given firm, would you expect the debt ratio to be as high as the debt/equity ratio? Explain.
7‑11. No, the debt ratio would not be as high as the debt/equity ratio because the debt ratio relates total liabilities to total assets, while the debt/equity ratio relates total liabilities to shareholders' equity. The total asset figure is equal to both the liabilities and the shareholders' equity.
13. Why is it important to compare long-term debt ratios of a given firm with industry averages?
7‑13. Industry averages tend to indicate the degree of debt that is considered to be acceptable for an industry. The industry average does not necessarily indicate the degree of debt that an individual firm should have, but it is the best indication of a reasonable amount outside of the individual firm. Comparing the company's ratios to the industry averages lets the company know if it is under performing or over performing the industry for example if the industry average for the debt ratio is 40% and the company's debt ratio is 30% then the company is carrying less debt than the other companies in that industry.
14. How should lessees account for operating leases? Capital leases? Include both income statement and balance sheet accounts.
7‑14. Operating leases simply require recording rent expense in the income statement accounts. Under a capital lease, the asset and related lease obligations are recorded on the balance sheet of the lessee. The lessee then records depreciation expense and interest expense as would be done if the asset had been acquired with a loan.
15. A firm with substantial leased assets that have not been capitalized may be overstating its long-term debt-paying ability. Explain.
7‑15. If a firm has not capitalized its leases, then its debt ratios will be lower than those of a firm that has capitalized leases because the lease will not be included in assets and liabilities on the company's balance sheet. Also, its times interest earned will be higher because interest expense is not included on the income statement, only rent expense. These two factors overstate the debt position.
16. Capital leases that have not been capitalized will decrease the times interest earned ratio. Comment.
7‑16. When capital leases are not capitalized then there will be less interest expense recorded on the income statement which means that the company will have less interest expense to cover thus lowering their times interest earned ratio.
20. Operating leases are not reflected on the balance sheet, but they are reflected on the income statement in the rent expense. Comment on why an interest expense figure that relates to long-term operating leases should be considered when determining a fixed charge coverage.
7‑20. An operating lease for a relatively long term is a type of long‑term financing. Therefore, a part of the lease payment, in reality, is a financing charge called interest. When a portion of operating lease payments is included in fixed charges, it is an effort to recognize the true total interest that the firm is paying.
22. Consider the debt ratio. Explain a position for including short-term liabilities from the debt ratio. Which of these approaches would be more conservative?
7‑22. Short‑term funds in total become part of the total sources of outside funds in the long run. Thus, short‑term funds should be included in the debt ratio. Another view is that the debt ratio is intended to relate long‑term outside sources of funds to total assets, and short‑term funds are not a valid part of long‑term funds. The approach that includes short‑term liabilities is the more conservative.
23. Consider the accounts of bonds payable and reserve for rebuilding furnaces. Explain how one of these accounts could be considered a firm liability and the other could be considered a soft liability.
7‑23. The bond payable account would represent a definite commitment that must be paid at some date in the future. This would be considered to be a firm liability. The reserve for rebuilding furnaces does not represent a firm commitment to pay out funds in the future, and when funds are used for rebuilding furnaces, this will be at the discretion of management. The reserve for rebuilding furnaces could be considered to be a soft liability account.
24. Explain why deferred taxes that are disclosed as long-term liabilities may not result in actual cash outlays in the future.
7‑24. The specific assets that caused the deferred tax will likely be replaced by similar specific assets in the future, and also the firm may expand. The replacement assets are likely to cost more than the original items. This would result in an additional deferred tax. This is the total firm view of deferred taxes, and this view indicates that the deferred tax amount may not result in actual cash outlays in the future. In any specific year, there may be a cash outlay because the firm may not have acquired sufficient assets in that year in relation to the assets being expensed.
25. A firm has a high current debt/net worth ratio in relation to prior years, competitors, and the industry. Comment on what this tentatively indicates.
7‑25. This tentatively indicates that this firm has higher risk in terms of paying commitments than it did in prior periods and in relation to competitors and the industry.
26. Comment on the implications of relying on a greater proportion of short-term debt in relation to long-term debt.
7‑26. This would indicate an increase in risk as management will more frequently be faced with debt coming due. It also indicates that short‑term debt is becoming a more permanent part of the financial structure of the firm.
27. When a firm guarantees a bank loan for a joint venture in which it participates and the joint venture is handled as an investment, then the overall potential debt position will not be obvious from the face of the balance sheet. Comment.
7‑27. This statement would be correct. . A guarantee of a loan is a type of contingent liability and unless it meets the standards for accruing such a liability it will be disclosed in a note to the financial statements. For readers of financial statements this guarantee will not be obvious from the face of the balance sheet.
28. When examining financial statements, a note that describes contingencies should be reviewed closely for possible significant liabilities that are not disclosed on the face of the balance sheet. Comment.
7‑28. True. Significant potential liabilities may be described in the contingency note. If a contingency loss meets one, but not both, of the criteria for recording and as a result is not accrued, disclosure by note is made when it is at least reasonably possible that there has been an impairment of assets or that a liability has been incurred.
12. Would a company that uses a natural business year tend to overstate or understate the liquidity of its receivables? Explain.
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 liquidity of receivables are the days' sales in receivables and the accounts receivable turnover. Because the receivables would be at or near their low point at the end of a natural business year, the days' sales in receivables would be low at the end of the year in comparison with usual days' sales in 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.
1.What is a ratio? How do ratios help to alleviate the problem of size differences among firms?
A ratio is a fraction comparing two numbers. Ratios make the comparisons in relative, rather than absolute, terms, which helps alleviate the problem of size difference.
3. What type of times interest earned ratio would be desirable? What type would not be desirable?
A relatively high, stable coverage of interest over the years is desirable. A relatively low, fluctuating coverage of interest over the years is not desirable.
36. Before computing the current ratio, the accounts receivable turnover and the inventory turnover should be computed. Why?
Accounts receivable and inventory are often major segments of current assets. Therefore, they can have a material influence on the current ratio. Accounts receivable turnover and the merchandise inventory turnover are ratios that will aid the analyst in forming an opinion as to the quality of receivables and inventory. Poor quality in receivables and/or inventory will increase the current ratio, which indicates better liquidity than is the case.
44. Why does LIFO result in a very unrealistic ending inventory figure in a period of rising prices?
Because the higher costs are reflected in the cost of sales (last in, first out), leaving old costs (lower) in inventory
3. What is the reason for separating current assets from the rest of the assets found on the balance sheet?
Current assets are assets that are in the form of cash or that will be realized in cash or that conserve the use of cash within an operating cycle of a business, or one year, whichever is the longer period of time. The other assets are not expected to be realized in cash in the near future and should, therefore, be segregated from current assets.
5. Define current assets.
Current assets are assets that are in the form of cash or that will be realized in cash or that conserve the use of cash within the operating cycle of a business, or one year, whichever is the longer period of time.
24. Define current liabilities
Current liabilities are obligations whose liquidation is reasonably expected to require the use of existing current assets or the creation of other current liabilities within a year or an operating cycle, whichever is longer.
18. The number of days' sales in inventory relates the amount of ending inventory to the average daily cost of goods sold. Explain why this computation may be misleading under the following conditions: a. The company uses a natural business year for its accounting period
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 the average daily cost of goods sold for the year is divided into the ending inventory, the resulting answer will be a lower number of days' sales in inventory than actually exists.
45. The cost of inventory at the close of the calendar year of the first year of operation is $40,000, using LIFO inventory, resulting in a profit before tax of $100,000. If the FIFO inventory would have een $50,000 what would the reported profit before tax have been? If the average cost method would have resulted in an inventory of $45,000, what would the reported profit before tax have been? Should the inventory costing method be disclosed? Why?
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 Yes, the inventory costing method should be disclosed. The disclosure is necessary to have an understanding of how the amount was computed.
38. Which inventory costing method results in the highest balance sheet amount for inventory? (Assume inflationary conditions)
FIFO represents the highest inventory balance under inflationary conditions.
5. Differentiate between horizonal and vertical analysis. Using sales as a component for each type, give an example that explains the difference.
Horizontal analysis expresses an item in relation to that same item for a previous base year. This analysis measures change over time. Example In 2010, sales were $750,000; in 2009, they were $500,000. Horizontal analysis shows 2010 sales as 150% of those in 2009. Vertical analysis compares one item with another base item for that same year. Example In 2010, selling expenses were $75,000 and sales were $750,000. Vertical analysis would show selling expenses as 10% of 2010 sales.
16.Describe the difference in inventories between a firm that is a retail company and a firm that is a manufacturing concern.
Inventories of a retail company are usually classified in one inventory account called "merchandise inventory." Inventories of a manufacturing concern are normally classified in three inventory accounts. These inventory accounts distinguish between getting ready to produce - raw material inventory; inventory in production, work in process inventory; and inventory completed - finished goods inventory.
37. Before computing the acid-test ratio, compute the accounts receivable turnover. Comment.
Receivables can have a material influence on the acid-test ratio. Accounts receivable turnover will give some indication as to the quality of receivables. Poor quality in receivables will increase the acid-test ratio, which will result in the acid-test ratio appearing to be more favorable than it actually is.
13. T. Melcher Co uses the calendar year. Sales are at a peak during the holiday season, and T. Melcher Co extends 30-day credit terms to customers. Comment on the expected liquidity of its receivables, based on the days' sales in receivables and the accounts receivable turnover.
Since the receivables will be at their peak at the end of the year, the days' sales in receivables will be high and the accounts receivable turnover will be low; thus, the liquidity will be understated when a firm closes its year at or near the peak of its business.
What is the NAICS number? How can it aid in the search of a company, industry, or product?
The North American Industry Classification system (NAICS) was created jointly by the United States, Canada, and Mexico. NAICS provides enhanced industry comparability among the three NAFTA trading partners. NAIS divides the economy into twenty sectors. Industries within these sectors are grouped according to the production criterion. Four sectors are largely goods-producing industries and sixteen sectors are entirely services-producing industries.
17. What is the SIC number? How can it aid in the search of a company, industry, or product?
The SIC is the Standard Industrial Classification. It was developed for use in the classification of establishments by type of activity in which they are engaged. Determining a company's SIC is a good starting point in your search of a company, industry, or product. Many library sources use the SIC number as a method of classification. Thus, knowing a company's SIC will be necessary in order to use some library sources.
12. Explain how the debt/equity ratio indicates the same relative long-term debt-paying ability as does the debt ratio, only in a different form.
The balance sheet equation has assets = liabilities + shareholders' equity. Given any set of figures that agree with the basic balance sheet equation, the liabilities are the same whether they are related to assets or shareholders' equity. For example, assets ($100,000) = liabilities ($40,000) + shareholders' equity ($60,000). Debt Ratio = $ 40,000 = 40% $100,000 Debt / Equity Ratio = $ 40,000 = 66 2/3% $60,000
7. Rachit Company has cash that has been frozen in a bank in Cuba. Should this cash be classified as a current asset?
The cash frozen in a bank in Cuba should not be classified as a current asset because it is not readily available to be used in operations.
21. One of the computations used to determine the liquidity of inventory determines the inventory turnover. In this computation, usually the average inventory is determined by using the beginning-of-the-year and the end-of-the-year inventory figures, but this computation can be misleading if the company has seasonal fluctuations or uses a natural business year. Suggest how to eliminate these distortions.
The distortions from seasonal fluctuations or the use of a natural business year can be eliminated by using monthly inventory figures when computing the average inventory that will then be divided into cost of goods sold.
15.If a company has substantial cash sales and credit sales, is there any meaning to the receivable liquidity computations that are based on gross sales?
The liquidity of the receivables will be overstated if the sales figure includes both cash sales and credit sales. The exact liquidity indicated by the days' sales in receivables and the accounts receivable turnover will be meaningless but the trend that can be determined from these computations will be meaningful.
17. During times of inflation, which of the inventory costing methods listed below would give the most realistic valuation of inventory? Which method would give the least realistic valuation of inventory? Explain.
The most realistic valuation of inventory would be the FIFO method because the most recent cost would be in the inventory. The LIFO method would result in the least realistic valuation of inventory. This is the result of having old cost in inventory.
4. Define operating cycle.
The operating cycle is the period of time elapsing between the acquisition of goods and the final cash realization resulting from sales and subsequent collections.
14. A company that uses a natural business year, or ends it year when business is at a peak, will tend to distort the liquidity of its receivables when end-of-year and beginning-of-year receivables are used in the computation. Explain how a company that uses a natural business year or ends its year when business is at a peak can eliminate the distortion in its liquidity computations.
This distortion can be eliminated by using the average monthly receivables figures in the liquidity computations. The average monthly receivables figure will eliminate the year's high or low in receivables.
8. AB Smith CO has guaranteed $1M bank note for Alender Company. How would this influence the liquidity ratios of AB Smith Co? How should this situation be considered?
This guaranteed note would not be recorded by A.B. Smith Company; therefore, it would not influence the liquidity ratios. The potential impact on the liquidity of A.B. Smith Company should be considered, because A.B. Smith Company could be called upon to pay the note. The guaranteed would be disclosed in a footnote to the financial statements.
9. Arrow Company has invested funds in a supplier to help ensure a steady supply of needed materials. Would this investment be classified as a marketable security?
This investment would not be classified as a marketable security because there is no intent to sell the securities and use the funds in current operations.
34. When a firm faces an inflationary condition and the LIFO inventory method is based on a periodic basis, purchases late in the year can have a substantial influence on profits. Comment.
This is true because the most recent purchases end up in cost of goods sold on the income statement.
35. Why could a current asset such as Net Assets of Business Held for Sale distort a firm's liquidity, in terms of working capital or the current ratio?
This type of a current asset would not be a normal recurring current asset. The firm's liquidity would be overstated in terms of normal sources.
39. Indicate the single most important factor that motivates a company to select LIFO.
Under inflationary conditions the cash flow under LIFO is greater than the cash flow under the other inventory methods by the difference in the resulting tax between the alternative cost methods.
22. Explain the influence of the use of LIFO inventory on the inventory turnover.
When prices are rising, the use of LIFO inventory will result in a much higher inventory turnover because of the lower inventory and the higher cost of goods sold. Therefore, the inventory turnover of a firm that uses LIFO should not be compared with the inventory turnover of a firm that does not use LIFO.
20. Some firms do not report the cost of goods sold separately on their income statements. In such a case, how should you proceed to compute days' sales in inventory? Will this procedure produce a realistic days' sales in inventory?
When the cost of goods sold is not available to compute days' sales in inventory, use net sales. The result will not be a realistic number of days' sales in inventory, but the result will be useful in comparing one period with another for the same firm and in comparing one firm with another firm, also using net sales.
23. Define working capital
Working capital is defined as current assets less current liabilities.
1.Is profitability important to a firm's long-term debt-paying ability? Discuss.
Yes, profitability is important to a firm's long‑term, debt- paying ability. Although the reported income does not agree with cash available in the short run, eventually the revenue and expense items do result in cash movements. Because there is a close relationship between the reported income and the ability of the entity to meet its long-run obligations, the major emphasis when determining the long‑term, debt-paying ability is on the profitability of the entity.
11. List the two computations that are used to determine the liquidity of inventory.
a. Number of days' sales in inventory b. Inventory turnover
10. List the two computations that are used to determine liquidity of receivables.
a. Number of days' sales in receivables b. Accounts receivable turnover
19. The days' sales in inventory is an estimate of the number of days that it will take to sell the current inventory. a. What is the ideal number of days' sales in inventory? b. In general, does a company want many days' sales in inventory? c. Can days' sales in inventory be too low?
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. b. In general, a company wants to minimize the days' sales in inventory. Excess inventory is expensive to the company. Some of these costs are storage cost, additional funds required, and financing cost. c. Days' sales in inventory can be too low, resulting in lost sales, limited production runs, higher transportation costs, etc.
-define each of these -if the book figures are based on cost, will the reults of the preceding computations tend to be understated or overstated? -What figures should be used in order to avoid the problem referred to in above b. Current ratio c. Acid test ratio d. Cash ratio
a. Working capital The excess of current assets over current liabilities. b. Current ratio The ratio of total current assets to total current liabilities. c. Acid-test ratio The ratio of total current assets less inventory to total current liabilities. d. Cash ratio The ratio of total current assets less inventory and receivables to 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 The current ratio will tend to be understated because inventory will be stated at amounts that do not represent current value. c. Acid-test ratio The acid-test ratio will tend to be accurate. d. Cash ratio The cash ratio will tend to be accurate. (3) To avoid the understatements in working capital and the current ratio, use the replacement (current) cost of inventory when it is disclosed.
6. List the major categories of items usually found in current assets.
a. cash d. inventories b. marketable securities e. prepayments c. receivables
2. What does each of the following categories of ratios attempt to measure? long-term borrowing capacity
b. Borrowing capacity measures the protection of long‑term creditors. Long-term bond holders would be particularly interested in these ratios.
18. The number of days' sales in inventory relates the amount of ending inventory to the average daily cost of goods sold. Explain why this computation may be misleading under the following conditions: b. The company closes the year when activities are at a peak.
b. If the company closes the year when the activities are at a peak, the number of days' sales in inventory would tend to be overstated and the liquidity would be understated. When the average daily cost of goods sold for the year is divided into the ending inventory, the resulting answer will be a higher number of days' sales in inventory than actually exists.
18. The number of days' sales in inventory relates the amount of ending inventory to the average daily cost of goods sold. Explain why this computation may be misleading under the following conditions: c. The company uses LIFO inventory, and inflation has been a problem for a number of years.
c. If the company uses LIFO inventory, the number of days' sales in inventory would tend to be understated during inflation because the inventory would be at low cost figures, while the cost of goods sold would be at higher current cost.
2. What does each of the following categories of ratios attempt to measure? profitability
c. Profitability means earning ability. Investors would be particularly interested in these ratios.
