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Unformatted text preview: Chapter 3 1. a. If inventory is purchased with cash, then there is no change in the current ratio. If inventory is purchased on credit, then there is a decrease in the current ratio if it was initially greater than 1.0. b. Reducing accounts payable with cash increases the current ratio if it was initially greater than 1.0. c. Reducing short-term debt with cash increases the current ratio if it was initially greater than 1.0. d. As long-term debt approaches maturity, the principal repayment and the remaining interest expense become current liabilities. Thus, if debt is paid off with cash, the current ratio increases if it was initially greater than 1.0. If the debt has not yet become a current liability, then paying it off will reduce the current ratio since current liabilities are not affected. e. Reduction of accounts receivables and an increase in cash leaves the current ratio unchanged. f. Inventory sold at cost reduces inventory and raises cash, so the current ratio is unchanged. g. Inventory sold for a profit raises cash in excess of the inventory recorded at cost, so the current ratio increases. 2. a. Quick ratio provides a measure of the short-term liquidity of the firm, after removing the effects of inventory, generally the least liquid of the firms current assets. b. Cash ratio represents the ability of the firm to completely pay off its current liabilities balance with its most liquid asset (cash). c. The capital intensity ratio tells us the dollar amount investment in assets needed to generate one dollar in sales. d. Total asset turnover measures how much in sales is generated by each dollar of firm assets. e. Equity multiplier represents the degree of leverage for an equity investor of the firm; it measures the dollar worth of firm assets each equity dollar has a claim to. f. Times interest earned ratio provides a relative measure of how well the firms operating earnings can cover current interest obligations. g. Profit margin is the accounting measure of bottom-line profit per dollar of sales. h. Return on assets is a measure of bottom-line profit per dollar of total assets. i . Return on equity is a measure of bottom-line profit per dollar of equity. j. Price-earnings ratio reflects how much value per share the market places on a dollar of accounting earnings for a firm. 1. Calculating Liquidity Ratios SDJ Inc has net working capital of $1410, current liabilities of $5810 and inventory of $1315. What is the current ratio? What is the quick ratio? To find the current assets, we must use the net working capital equation. Doing so, we find: NWC = Current assets Current liabilities $1,410 = Current assets $5,810. You then add current liabilities to NWC Current assets = $7,220 Now, use this number to calculate the current ratio and the quick ratio. The current ratio is: Current ratio = Current assets / Current liabilities Current ratio = $7,220 / $5,810 Current ratio = 1.24 times And the quick ratio is: Quick ratio = (Current assets Inventory) / Current liabilities...
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- Spring '08