This problem set covers all of our ratio analysis situations, with a general increase in degree of difficulty as we progress. Be sure that you have mastered the easier problems before moving ahead, because the more difficult examples tend to expand on the ideas presented in the easier ones. The last four problems are comprehensive, involving the interpretation of financial ratios that you compute or are given.
1. Compute Addison Amalgamated Airways’ current ratio and quick ratio, based on its most recent balance sheet:
Cash$ 700,000Accounts Payable$ 1,200,000
Marketable Securities 950,000Notes Payable 2,500,000 Accounts Receivable 1,250,000Long-Term Debt 1,600,000 Inventory 3,400,000Common Stock 4,250,000
Net Fixed Assets 6,550,000Retained Earnings 3,300,000 Total Assets$12,850,000 Total Claims$12,850,000
Type: Computing liquidity ratios. In computing the current and quick ratios, we try to see whether the commitments the firm had made, as of the moment when the most recent balance sheet “snapshot” was taken, would lead to more money coming in over the subsequent year than would be paid out over the subsequent year (and by a sufficient margin). So these ratios offer insights into whether the company is “liquid” in terms of expecting to have enough money to pay its bills that will come due over the reasonably short term. An extreme interpretation of these two “snapshot”-based ratios would be as measures of the firm’s ability to pay the bills it has already agreed to pay, if it goes out of business today and never incurs another receivable or payable. A less extreme way to think about any balance sheet-based ratio is that the most recent “snapshot” figure is (unless we know it is not) a good representation of the company’s ongoing situation with regard to that asset or claim. Recall that the current ratio is computed as
Current Ratio = [pic] ,
which requires us to do some adding here because the current asset and current liability figures are not totaled in the balance sheet given. The current asset categories shown in this balance sheet are cash, marketable securities, accounts receivable, and inventory [fixed assets, such as buildings and machines, have long useful lives and thus would not be expected to be “liquidated,” or turned into cash (i.e., sold), within a “current” short time period like a year]. Current liability categories shown in this balance sheet are accounts payable and notes payable; the other right-hand side figures all involve amounts that money providers do not expect to receive until a more distant future date. So we can compute Current Ratio = [pic] = 1.703 .
Thus it seems like the company has a reasonable cushion; the money it stands to collect over the next year (along with what it already has in cash) is 1.7 times (170% of) what it expects to pay out over the next year. But the cushion might be less than it appears on the surface if inventory ends up being hard to sell. Cash is already in the company’s checking account, and marketable securities are available with a phone call to the company’s stock broker (think of marketable securities as the company’s savings account), while accounts receivable represent dollar amounts that buyers of the company’s goods or services have already agreed to pay after a short wait. But what if inventory items the company holds for sale (or for use in producing goods for sale) end up being unsalable, perhaps because of customers’ changing desires? A more conservative measure of the company’s liquidity position (which we might pay careful attention to if inventory tends to be illiquid for firms like Addison) is the quick ratio, computed as
Quick Ratio = [pic] .
Removing the $3,400,000 inventory from the numerator of the...