ANSWERS AND SOLUTIONS TO CHAPTER 4 DIFFICULT PROBLEMS

PROBLEM 4-15 (P.144)

Note. There two questions for this problem. The question on current ratio will be the one
to be answered. The other question will be answered after the related topic is
discussed in the next meetings.

The existing quick ratio for the firm is

= (10K + 50K)/ 50K = 1.20

while the existing current ratio is

= 210K/50K = 4.20

The owner wants to reduce the current ratio to 2.5 by reducing the excessive
inventories.

The transactions involved are selling of inventories, collection of sales (either cash or
credit sales) and reducing of common equity (or repurchasing of shares more
commonly known as treasury shares).

The above transactions have no effect

a) On the receivables because either the sale is a cash transaction or the

receivables debited from the sale on account is eventually credited due to the
collection. It was stated that the funds generated (meaning cash is already
collected from the sale of inventory) will be used to reduce common equity.
b) No effect on the cash because the cash debited from the collection of sales or
receivable will be credited to repurchase equity.
c) No effect on current liabilities because neither the accounts payable nor the
notes payable will be involved and affected in the said transactions.

Hence, if the target current ratio is 2.50, then the new current assets (given that
current liabilities stay the same) will be

2.50 = Current Assets/ 50K Current Assets = 2.50 x 50K = 125K

Current assets will be reduced by 85K (210K less 125K).

Since cash and receivables will not be affected and will not change , the reduction in
current assets will be on the inventories.

New inventories (to achieve the current ratio of 2.50) will be = 150K – 85K = 65K.

However, quick ratio stays the same, since only the inventories changed, which are
excluded in computing for the quick ratio. Cash, receivables and current liabilities,
variables used to compute for the quick ratio, will not change. New quick ratio is still
1.20 (as computed above).
PROBLEM 4-19 (P.145)

1,312,500
Present current ratio = 525,000 = 2.5.

1,312,500 + Δ NP
Minimum current ratio = 525,000 + ΔNP = 2.0.

1,312,500 + NP = 1,050,000 + 2NP

NP = 262,500.
Short-term debt can increase by a maximum of 262,500 without violating a 2-
to-1 current ratio, assuming that the entire increase in notes payable is used to
increase current assets. Since we assumed that the additional funds would be
used to increase inventory, the inventory account will increase to 637,500 and
current assets will total 1,575,000, and current liabilities will total 787,500.

The common error in answering this type of problem is to only consider the NP
or the X or the unknown variable in the denominator and not to both the
numerator and denominator.

Since the question is the increase in short-term debt (part of the denominator
in the current ratio formula), we overlook the overall effect of all the
transactions involved to the current ratio, in which the numerator is also
affected.

The first transaction, raising funds thru additional notes payable, both
increases current assets (debit cash) and current liabilities (credit notes
payable). The second transaction, purchase of inventory thru cash, both
increases current assets ( debit inventories) and decreases current assets (credit
cash). The net effect of the second transaction to current assets or current ratio
is zero or none (due to offsetting).

Hence, the overall or combined effect of the two transactions is the increase in
both current assets and current liabilities (by an equal amount), which is
actually the effect of the first transaction. The unknown variable, which is the
increase, should be included in both the numerator and denominator of the
current ratio formula.

PROBLEM 4-20 (P.145)

Step 1: Solve for current annual sales using the DSO equation:
55 = 750,000/(Sales/365)
55Sales = 273,750,000
Sales = 4,977,272.73.

OR
 Sales = (AR/DSO*) x 365days
= (750,000/55) x 365
= 13,636.36* x 365
= 4,977,272.73.

*This pertains to the daily sales

Step 2:If sales fall by 15%, the new sales level will be 4,977,272.73(0.85) =
4,230,681.82. Again, using the DSO equation, solve for the new
accounts receivable figure as follows:
35 = New AR/(4,230,681.82/365)
35 = New AR/11,590.91
New AR = 405,681.82  405,682.

OR

New AR = New Daily sales x New DSO

= (4,230,681.82/365) x 35 days
= 11,590.91 x 35
= 405,681.82

Is it logical that sales will be reduced if we make efforts to reduce our DSO? The
answer is yes.

If we pressure customers to pay their bills on time to reduce the DSO, this may
turn-off or hurt other customers who may switch to other firms which will give
them more relaxed credit terms and less-pressured collection policy.