Question

(Ratio Computations and Analysis) Prior Company’s condensed financial statements provide the following information.

PRIOR COMPANY BALANCE SHEET

	Dec 31, 2017	Dec 31, 2016
Cash	\(52,000	\)60,000
Accounts receivable	198,000	80,000
Short-term investment	80,000	40,000
Inventory	440,000	360,000
Prepaid expenses	3,000	7,000
Total current assets	\(773,000	\)547,000
Property, plant and equipment (net)	857,000	853,000
Total assets	\(1,630,000	\)1,400,000
Current liabilities	240,000	160,000
Bond payable	400,000	400,000
Common stockholder’s equity	990,000	840,000
Total liabilities and stockholder’s equity	\(1,630,000	\)1,400,000

Particular	Amount \(
Sales revenue	\)1,640,000
Cost of goods sold	(800,000)
Gross profit	840,000
Selling and administrative expenses	(440,000)
Interest expenses	(40,000)
Net income	$360,000

Instructions

(a) Determine the following for 2017.

(1) Current ratio at December 31.

(2) Acid-test ratio at December 31.

(3) Accounts receivable turnover.

(4) Inventory turnover.

(5) Return on assets.

(6) Profit margin on sales.

(b) Prepare a brief evaluation of the financial condition of Prior Company and of the adequacy of its profits.

Short answer

1. Financial ratios:

Current ratio	3.22 times
Acid test ratio	1.375 times
Accounts receivable turnover	11.80 times
Inventory turnover	2 times
Return on asset	23.76%
Profit margin on sales	21.95%

2. The financial ratios calculated above reflect the good position of the business entity in terms of profitability.

Step-by-step solution

Definition of Financial Ratios

All the financial metrics that determine the business position by comparing various line items of the financial statement are known as financial ratios. It depicts the business entity's profitability, solvency, liquidity, and efficiency.

Calculation of ratios

(1) Current ratio at December 31

$\begin{array}{rcl}\mathrm{Current}\mathrm{ratio}& =& \frac{\mathrm{Current}\mathrm{assets}}{\mathrm{Current}\mathrm{liabilities}}\\ & =& \frac{\$773,000}{\$240,000}\\ & =& 3.22\mathrm{times}\end{array}$

(2) Acid-test ratio at December 31

$\begin{array}{rcl}\mathrm{Acid}-\mathrm{test}\mathrm{ratio}& =& \frac{\mathrm{Current}\mathrm{assets}-\mathrm{Inventory}-\mathrm{Prepaid}\mathrm{expenses}}{\mathrm{Current}\mathrm{liabilities}}\\ & =& \frac{\$773,000-\$440,000-\$3,000}{\$240,000}\\ & =& 1.375\mathrm{times}\end{array}$

(3) Accounts receivable turnover

$\begin{array}{rcl}\mathrm{Accounts}\mathrm{receivable}\mathrm{turnover}\mathrm{ratio}& =& \frac{\mathrm{Net}\mathrm{sales}}{\mathrm{Average}\mathrm{accounts}\mathrm{receivables}}\\ & =& \frac{\$1,640,000}{{\displaystyle \frac{\$198,000+\$80,000}{2}}}\\ & =& \frac{\$1,640,000}{\$139,000}\\ & =& 11.80\mathrm{times}\end{array}$

(4) Inventory turnover

$\begin{array}{rcl}\mathrm{Inventory}\mathrm{turnover}\mathrm{ratio}& =& \frac{\mathrm{Cost}\mathrm{of}\mathrm{goods}\mathrm{sold}}{\mathrm{Average}\mathrm{Inventory}}\\ & =& \frac{\$800,000}{{\displaystyle \frac{\$440,000+\$360,000}{2}}}\\ & =& \frac{\$800,000}{\$400,000}\\ & =& 2\mathrm{times}\end{array}$

(5) Return on assets

$\begin{array}{rcl}\mathrm{Return}\mathrm{on}\mathrm{assets}& =& \frac{\mathrm{Net}\mathrm{income}}{\mathrm{Average}\mathrm{total}\mathrm{assets}}\times 100\\ & =& \frac{\$360,000}{{\displaystyle \frac{\$1,630,000+\$1,400,000}{2}}}\times 100\\ & =& \frac{\$360,000}{\$1,515,000}\times 100\\ & =& 23.76\%\end{array}$

(6) Profit margin on sales

$\begin{array}{rcl}\mathrm{Profit}\mathrm{margin}\mathrm{on}\mathrm{sales}& =& \frac{\mathrm{Net}\mathrm{margin}}{\mathrm{Sales}}\times 100\\ & =& \frac{\$360,000}{\$1,640,000}\times 100\\ & =& 21.95\%\end{array}$

Evaluation of ratios

According to the financial ratios calculated above, it can be stated that the business entity is performing well in terms of profitability because the return on asset and profit margin ratio reflects that the business can use its assets efficiently.

From a short-term point of view, the inventory turnover ratio is developing a concern because it is relatively low than the usual inventory turnover ratio.