2015 2016 2017 The current ratio is increasing while the acid-test (quick) ratio
ID: 2577830 • Letter: 2
Question
2015
2016
2017
The current ratio is increasing while the acid-test (quick) ratio is decreasing. Using the ratios provided, identify and explain the contributing factor(s) for this apparently divergent trend.
Picasso Company is a wholesale distributor of packaging equipment and supplies. The company’s sales have averaged about $900,000 annually for the 3-year period 2015–2017. The firm’s total assets at the end of 2017 amounted to $850,000.The president of Picasso Company has asked the controller to prepare a report that summarizes the financial aspects of the company’s operations for the past 3 years. This report will be presented to the board of directors at their next meeting.
In addition to comparative financial statements, the controller has decided to present a number of relevant financial ratios which can assist in the identification and interpretation of trends. At the request of the controller, the accounting staff has calculated the following ratios for the 3-year period 2015–2017.
2015
2016
2017
Current ratio 1.80 1.89 1.96 Acid-test (quick) ratio 1.04 0.99 0.87 Accounts receivable turnover 8.75 7.71 6.42 Inventory turnover 4.91 4.32 3.42 Debts to assets 51.0 % 46.0 % 41.0 % Long-term debt to assets 31.0 % 27.0 % 24.0 % Sales to fixed assets (fixed asset turnover) 1.58 1.69 1.79 Sales as a percent of 2015 sales 1.00 1.03 1.07 Gross margin percentage 36.0 % 35.1 % 34.6 % Net income to sales 6.9 % 7.0 % 7.2 % Return on assets 7.7 % 7.7 % 7.8 % Return on common stock equity 13.6 % 13.1 % 12.7 %In preparation of the report, the controller has decided first to examine the financial ratios independent of any other data to determine if the ratios themselves reveal any significant trends over the 3-year period.
Explanation / Answer
The acid-test ratio is cash plus receivables divided by current liabilities. In other words it is the current ratio minus inventories. Any divergence in trend between the acid-test ratio and the current ratio would be dependent on the inventory account. Inventory turnover has declined sharply in the three-year period, from 4.91 to 3.72.
Total sales have increased by 5 % so the decline in inventory turnover is not due to a decline in sales. The cause is that investment in inventory has increased at a faster rate than sales; and this has created the divergence between the acid-test and current ratios
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