Question

(Ratio Computations and Effect of Transactions) Presented below is information related to Carver Inc.

CARVER INC. BALANCE SHEET DECEMBER 31, 2017

	Amount \(	Amount \)		Amount \(
Cash		\)45,000	Note payable (short-term)	\(50,000
Receivables	\)110,000		Account payable	32,000
Less: Allowance	15,000	95,000	Accrued liabilities	5,000
Inventory		170,000	Common stock (par \(5)	260,000
Prepaid insurance		8,000	Retained earnings	141,000
Land		20,000
Equipment net		150,000
		\)488,000		\(488,000

CARVER INC. INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2017

Sales revenue		\)1,400,000
Cost of goods sold
Inventory Jan 1, 2017	\(200,000
Purchases	790,000
Cost of goods available for sale	990,000
Inventory Dec 31, 2017	(170,000)
Cost of goods sold		(820,000)
Gross profit on sales		580,000
Operating expenses		(170,000)
Net income		\)410,000

Instructions

(a) Compute the following ratios or relationships of Carver Inc. Assume that the ending account balances are representative unless the information provided indicates differently.

(1) Current ratio.

(2) Inventory turnover.

(3) Accounts receivable turnover.

(4) Earnings per share.

(5) Profit margin on sales.

(6) Return on assets on December 31, 2017.

(b) Indicate for each of the following transactions whether the transaction would improve, weaken, or have no effect on the current ratio of Carver Inc. at December 31, 2017.

(1) Write off an uncollectible account receivable, \(2,200.

(2) Purchase additional capital stock for cash.

(3) Pay \)40,000 on notes payable (short-term).

(4) Collect $23,000 on accounts receivable.

(5) Buy equipment on account.

(6) Give an existing creditor a short-term note in settlement of account.

Short answer

1. Financial ratios

Current ratio	3.65 times
Inventory turnover ratio	4.43 times
Accounts receivable turnover ratio	14.73 times
Earnings per share	7.88 times
Profit margin on sales	29.28%
Return on assets	84%

2. Effect on current ratio:

Transaction	Effect
1	No effect
2	Decrease
3	Increase
4	No effect
5	Decrease
6	No effect

Step-by-step solution

Definition of Current Ratio

The current ratio can be defined as the financial metric that determines the liquidity of the business entity through the comparison of the current assets and current liabilities.

Calculation of financial ratios

(1) Current ratio

$\begin{array}{rcl}\mathrm{Current}\mathrm{ratio}& =& \frac{\mathrm{Current}\mathrm{assets}}{\mathrm{Current}\mathrm{liabilities}}\\ & =& \frac{\$318,000}{\$87,000}\\ & =& 3.65\mathrm{times}\end{array}$

(2) Inventory turnover

$\begin{array}{rcl}\mathrm{Inventory}\mathrm{turnover}& =& \frac{\mathrm{Cost}\mathrm{of}\mathrm{goods}\mathrm{sold}}{\mathrm{Average}\mathrm{inventory}}\\ & =& \frac{\$820,000}{{\displaystyle \frac{\$200,000+\$170,000}{2}}}\\ & =& \frac{\$820,000}{\$185,000}\\ & =& 4.43\mathrm{times}\end{array}$

(3) Accounts receivable turnover

$\begin{array}{rcl}\mathrm{Account}\mathrm{receivable}\mathrm{turnover}& =& \frac{\mathrm{Net}\mathrm{sales}}{\mathrm{Average}\mathrm{accounts}\mathrm{receivable}}\\ & =& \frac{\$1,400,000}{\$95,000}\\ & =& 14.73\mathrm{times}\end{array}$

(4) Earnings per share

$\begin{array}{rcl}\mathrm{Earnings}\mathrm{per}\mathrm{sale}& =& \frac{\mathrm{Net}\mathrm{income}}{\mathrm{Outstanding}\mathrm{common}\mathrm{shares}}\\ & =& \frac{{\displaystyle \frac{\$410,000}{\$260,000}}}{5}\\ & =& 7.88\mathrm{times}\end{array}$

(5) Profit margin on sales

$\begin{array}{rcl}\mathrm{Profit}\mathrm{margin}\mathrm{on}\mathrm{sales}& =& \frac{\mathrm{Net}\mathrm{income}}{\mathrm{Sales}}\times 100\\ & =& \frac{\$410,000}{\$1,400,000}\times 100\\ & =& 29.28\%\end{array}$

(6) Return on assets on December 31, 2017

$\begin{array}{rcl}\mathrm{Return}\mathrm{on}\mathrm{assets}& =& \frac{\mathrm{Net}\mathrm{income}}{\mathrm{Average}\mathrm{total}\mathrm{assets}}\times 100\\ & =& \frac{\$410,000}{\$488,000}\times 100\\ & =& 84\%\end{array}$

Effect of transactions over the current ratio

1. Writing off uncollectible receivables will not affect the current ratio because these receivables are already included in the allowance for doubtful accounts when estimations for bad debts are made.
2. The purchasing of capital stock for cash will reduce the cash balance and the current assets of the company. Therefore, it will reduce or weaken the current ratio.
3. Paying notes payable will reduce the current assets and liabilities by the same amount and it will increase the current ratio of the business entity.
4. Payment made to receivables will not have any effect on the current ratio because both current assets and current liabilities will remain the same.
5. When the equipment is purchased on account current liabilities increases which will weaken the current ratio.
6. Settlement of account by paying a short-term note will not affect the current liability and current assets of the business entity. Therefore, it will not have any effect on the current ratio of the business entity.