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Unformatted text preview: S3-1 CHAPTER 3 WORKING WITH FINANCIAL STATEMENTSLearning Objectives LO1 The sources and uses of a firm’s cash flows.LO2 How to standardize financial statements for comparison purposes. LO3 How to compute and, more importantly, interpret some common ratios. LO4 The determinants of a firm’s profitability.LO5 Some of the problems and pitfalls in financial statement analysis. Answers to Concepts Review and Critical Thinking Questions 1.(LO2)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.(LO2)The firm has increased inventory relative to other current assets; therefore, assuming current liability levels remain unchanged, liquidity has potentially decreased. 3. (LO2) A current ratio of 0.50 means that the firm has twice as much in current liabilities as it does in current assets; the firm potentially has poor liquidity. If pressed by its short-term creditors and suppliers for immediate payment, the firm might have a difficult time meeting its obligations. A current ratio of 1.50 means the firm has 50% more current assets than it does current liabilities. This probably represents an improvement in liquidity; short-term obligations can generally be met completely with a safety factor built in. A current ratio of 15.0, however, might be excessive. Any excess funds sitting in current assets generally earn little or no return. These excess funds might be put to better use by investing in productive long-term assets or distributing the funds to shareholders. S3-2 4. (LO2) 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 firm’s current assets....
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