Required: In each case, give an example of circumstances underlying the that might represent an unfavorable development. ANS: a. A high current ratio can mean overstocked inventory or doubtful receivables. Either of these accounts being high could cause the current ratio to be misleading. b. The firm may have substantially tightened its credit policy. This might have resulted in a major loss of customers. c. Rapidly rising turnover might mean that production is unable to generate goods as quickly as possible and that the firm is running a risk of stockouts. 3. Required: How will switching from fifo to lifo for inventory valuation affect financial analysis of liquidity and profitability? Cite two ratios that will be affected and indicate how they will change. (Assume an inflationary condition.) ANS: Lifo inventory valuation results in higher cost of sales and lower inventory valuation. It will cause lower profitability and tax outflow. Merchandise inventory turnover will appear much higher, since the cost of sales will be higher and average inventory much lower. Days' sales in inventory will be lower, since the cost of sales will be higher, giving higher daily cost of sales to divide into lower inventory. The liquidity position will be reduced in terms of working capital and the current ratio. 4. DeCort Company's working capital accounts at December 31, 2009, are given below: Current Assets: Cash $100,000 Marketable Securities 50,000 Accounts Receivable $250,000 Less Allowance for Doubtful Accounts (20,000) 230,000 Inventory, Lifo 300,000 Prepaid 8,000 Total Current Assets $688,000 Current Liabilities: Accounts Payable $200,000 Notes Payable 50,000 Payable 10,000 Accrued Liabilities 30,000 Total Current Liabilities $290,000 During 2010, DeCort Company completed the following transactions: a. Purchased fixed assets for cash, $20,000.
Required: In each case, give an example of circumstances underlying the that might represent an unfavorable development. ANS: a. A high current ratio can mean overstocked inventory or doubtful receivables. Either of these accounts being high could cause the current ratio to be misleading. b. The firm may have substantially tightened its credit policy. This might have resulted in a major loss of customers. c. Rapidly rising turnover might mean that production is unable to generate goods as quickly as possible and that the firm is running a risk of stockouts. 3. Required: How will switching from fifo to lifo for inventory valuation affect financial analysis of liquidity and profitability? Cite two ratios that will be affected and indicate how they will change. (Assume an inflationary condition.) ANS: Lifo inventory valuation results in higher cost of sales and lower inventory valuation. It will cause lower profitability and tax outflow. Merchandise inventory turnover will appear much higher, since the cost of sales will be higher and average inventory much lower. Days' sales in inventory will be lower, since the cost of sales will be higher, giving higher daily cost of sales to divide into lower inventory. The liquidity position will be reduced in terms of working capital and the current ratio. 4. DeCort Company's working capital accounts at December 31, 2009, are given below: Current Assets: Cash $100,000 Marketable Securities 50,000 Accounts Receivable $250,000 Less Allowance for Doubtful Accounts (20,000) 230,000 Inventory, Lifo 300,000 Prepaid 8,000 Total Current Assets $688,000 Current Liabilities: Accounts Payable $200,000 Notes Payable 50,000 Payable 10,000 Accrued Liabilities 30,000 Total Current Liabilities $290,000 During 2010, DeCort Company completed the following transactions: a. Purchased fixed assets for cash, $20,000.
Ch06%20Liquidity%20of%20short%20term%20asset.docx