Shown below are selected financial data for AB and XY Limited at the end of the current year: AB...

Question:

Shown below are selected financial data for AB and XY Limited at the end of the current year:

AB Ltd XY Ltd
Net credit sales $675,000 $560,000
Cost of goods sold 504,000 480,000
Cash 51,000 20,000
Accounts receivable 75,000 70,000
Inventory 84,000 160,000
Current liabilities 105,000 100,000

Required:

a) For each of the two companies, compute the following:

1. Working capital.

2. Current ratio.

3. Quick ratio.

4. Inventory turnover ratio and an average number of days required to turn over inventory.

5. Accounts receivable ratio and average accounts receivable collection period.

b) From the viewpoint of a short-term creditor, comment on the quality of each company's working capital. To which company would you prefer to sell $20,000 in goods on a 30-day open account?

Financial Analysis:

Financial analysis is a powerful accounting tool which utilizes various factors to determine the resiliency of an operation. Any aspect of the balance sheet, income statement, and statement of cash flow can by analyzed.

Answer and Explanation:

Ratios are a powerful financial analysis tool which assesses aspects such as liquidity, leverage, profitability, and efficiency to uncover trends of an operation.


AB Ltd XY Ltd
Net credit sales $675,000 $560,000
Cost of goods sold 504,000 480,000
Cash 51,000 20,000
Accounts receivable 75,000 70,000
Total Quick Assets 126,000 90,000
Inventory 84,000 160,000
Total Current Assets 210,000 250,000
Current liabilities 105,000 100,000
Working Capital (Total Current Assets - Total Current Liabilities) 105,000 150,000
Current Ratio (Total Current Assets / Total Current Liabilities) 2.00 2.50
Quick Ratio (Total Quick Assets / Total Current Liabilities) 1.20 0.90
Inventory Turnover (Cost of Goods Sold / Average Inventory) 6.00 3.00
Inventory Days (365 / Inventory Turnover) 60.83 121.67
Accounts Receivable Turnover (Sales / Average Receivables) 9.00 8.00
Receivable Days (365 / Accounts Receivable Turnover) 40.56 45.63


a) Ratios:


1. Working capital.


Working capital is a liquidity ratio which assesses the dollar comparison of total current assets to total current liabilities. The ratio reports the amount of current assets remaining after servicing current liabilities. A positive ratio indicates excess capacity where a negative ratio indicates a reliance on other assets to support operations. Working capital is calculated by subtracting total current assets from total current liabilities.


2. Current ratio.


Current ratio is a liquidity ratio which determines the number of times total current assets service total current liabilities. A ratio in excess of 1:1 indicates excess capacity where a ratio of less than 1:1 indicates a deficiency. A ratio of 1:1 indicates that 100% of current assets would be needed to service 100% of current liabilities. The ratio is calculated by dividing total current assets by total current liabilities.


3. Quick ratio.


Quick ratio is a liquidity ratio which determines the number of times the most liquid current ratios service total current liabilities. A ratio in excess of 1:1 indicates excess capacity where a ratio of less than 1:1 indicates a deficiency. A ratio of 1:1 indicates that 100% of current assets would be needed to service 100% of current liabilities. The ratio is calculated by dividing the sum of total current assets minus inventory and prepaids by total current liabilities.


4. Inventory turnover ratio and an average number of days required to turn over inventory.


Inventory turnover is an efficiency ratio which indicates the number of times a company was able to purchase and sell inventory during a year. The ratio is calculated by dividing cost of goods sold by average inventory. Inventory days are calculated by dividing 365 by the inventory turnover days. The inventory turnover days reports the average number of days it takes a company to sell the inventory in stock.


5. Accounts receivable ratio and average accounts receivable collection period.


Accounts Receivable turnover is an efficiency ratio which indicates the number of times a company was able to collect credit sales during a year. The ratio is calculated by dividing sales by average receivables. Receivable days are calculated by dividing 365 by the account receivable days. The accounts receivable days reports the average number of days it takes a company to convert credit sales to cash.


b) From the viewpoint of a short-term creditor, comment on the quality of each company's working capital. To which company would you prefer to sell $20,000 in goods on a 30-day open account?


From the standpoint of a short-term creditor I would prefer to sell goods to AB Ltd because of the quicker inventory turnover and conversion of receivables to cash. The company has the more favorable quick ratio which indicates a greater ability to service current obligations.


Learn more about this topic:

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Ratios and Proportions: Definition and Examples

from Geometry: High School

Chapter 7 / Lesson 1
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