Financial Reporting and Analysis (Chapter # 6 – Liquidity of Short Term Assets) by Charles H. Gibson

Financial Reporting and Analysis by Charles H. Gibson 13th Edition

Chapter # 6 – Liquidity of Short Term Assets

P  6-1:  In this problem,  compute the acid-test ratio as follows:

 Current  Assets -Inventory  

    Current Liabilities

Required:  Determine the cost of sales of a firm with the following financial data.
Current  ratio                                                                                    2.5
Quick ratio or acid-test                                                                   2.0
Current  liabilities                                                                  $400,000
Inventory turnover                                                                    3 times
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Financial Reporting and Analysis (Chapter # 6 – Liquidity of Short Term Assets) by Charles H. Gibson 12th Edition


Hawk  Company wants to determine the liquidity of its receivables. It has supplied you with the following data regarding  selected accounts for December 31, 2011,  and 2010:
                                                                                       2011        2010
Net sales
Receivables, less allowance for losses and discounts $1,180,178 $2,200,000
Beginning of year (allowance for losses and
discounts,  2011—$12,300; 2010—$7,180)                      240,360           230,180
End of year (allowance for losses and discounts,
2011—$11,180; 2010—$12,300)                                      220,385           240,360 

a.   Compute the number of days’ sales in receivables at December 31, 2011, and 2010.
b.   Compute the accounts receivable turnover for 2011 and 2010. (Use year-end gross 
c.   Comment  on the liquidity of Hawk  Company  receivables
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a.                                                    Gross Receivables

Days’ sales in
=     Net Sales/365


2003:  $220,385 +
 = 71.62 days



2002:  $240,360 +
 = 41.92 days

C.:  The Hawk Company receivables have been much less liquid in 2003 in comparison with 2002. The days’ sales in receivables at the end of the year have increased from 41.92 days in 2002 to 71.62 days in 2003. The accounts receivable turnover declined in 2003 to 4.87 from a turnover of 8.98 in 2002. These figures represent a major deterioration in the liquidation of receivables. The reasons for this deterioration should be determined.  Some possible reasons are a major customer not paying its bills, a general deterioration of all receivable accounts, or a change in the Hawk Company credit terms.
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Mr. Williams, the owner of Williams Produce, wants to maintain control over accounts receivable. He understands that days’ sales in receivables and accounts receivable turnover will give a good indication of how well receivables are being managed.  Williams Produce does 60%  of its business during June, July, and August. Mr. Williams provided the following pertinent data:

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Financial Reporting and Analysis (Chapter # 6 – Liquidity of Short Term Assets) by Charles H. Gibson 12th Edition

C: This company appears to have a seasonal business because of the materially different days’ sales in receivables and accounts receivable turnover when computed on the two different dates.  The ratios computed will not be meaningful in an absolute sense, but they would be meaningful in a comparative sense when comparing the same dates from year to year. They would not be meaningful when comparing different dates. 


L. Solomon  Company would like to compare its days’ sales in receivables with that of a competitor, L. Konrath  Company.  Both companies have had similar sales results in the past, but L. Konrath  Company has had better profit results. L. Solomon  Company suspects that one reason for the better profit results is that  L. Konrath  Company did a better job of managing receivables. L. Solomon  Company uses a calendar year that ends on  December 31, while L. Konrath  Company uses a fiscal year that ends on July 31. Information related to sales and receivables of the two companies follows: 
Financial Reporting and Analysis (Chapter # 6 – Liquidity of Short Term Assets) by Charles H. Gibson 12th Edition
a.   Compute the days’ sales in receivables for both companies.  (Use year-end gross receivables.)
b.   Comment on the results.

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b. It appears that the L. Konrath Company manages receivables better than L. Solomon Company. They have 12.6 days’ sales in receivables while the L. Solomon Company has 23.9 days’ sales in receivables. Actually, we cannot make a fair comparison between these two companies because the L. Solomon Company is using the calendar year while the L. Konrath Company appears to be using a natural business year.  By using a natural business year, the L. Konrath Company 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.

 6-8: The inventory and sales data for this year for G. Rabbit Company are as follows:


Using the above data from G. Rabbit  Company,  compute the following:
a.   The accounts receivable turnover in days 
b.   The inventory turnover in days
c.   The operating  cycle
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A partial  balance sheet and income statement  for King Corporation follow:

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Note: The trade  receivables at December 31, 2010, were $280,000, net of an allowance of
$8,000,  for a gross receivables figure of $288,000. The inventory at December 31, 2010, was $565,000.

Required: Compute  the following:

a. Working capital
b. Current ratio
c. Acid-test ratio
d. Cash ratio
e. Days’ sales in receivables
f. Accounts receivable turnover in days
g. Days’ sales in inventory
h. Inventory turnover in days
i. Operating cycle

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The  following  financial  data  were  taken  from  the  annual  financial  statements  of Smith Corporation:
a.   Based on these data,  calculate the following for 2010 and 2011:
1.  Working  capital
2.  Current  ratio
3.  Acid-test ratio
4.  Accounts receivable turnover
5.  Merchandise inventory  turnover
6.  Inventory  turnover  in days
b.   Evaluate the results of your computations in regard to the short-term liquidity of the firm.

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The short-term liquidity of the firm improved between  2003 and 2004.  The working capital increased by $60,000, while the current ratio increased from 1.33 to 1.47.  The acid-test ratio increased from .67 to .74.  Using a rule of thumb of two for the current ratio and one for the acid test, this firm needs to improve its current liquidity position.
The accounts receivable turnover stayed the same, while the inventory improved from 4.25 to 4.98. The days’ sales in inventory improved from 85.88 to 73.29 days.
Much of the improvement in the current position can be attributed to the improved control of the inventory.

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