Working Capital and Liquidity #2 Quick Test

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1. A current asset is a company’s resource that is expected to be converted to cash within one year or within the operating cycle, whichever is ____________.

While the general rule is one year, there are some industries where it requires more than one year to process its products. In those industries a current asset is one that is expected to be converted to cash within the operating cycle.
2. Which of the following will increase the total amount of a company’s working capital?

For the total amount of working capital to change, there must be a transaction that involves a working capital account and an account that is outside of the working capital accounts. (The working capital accounts are the current asset accounts and the current liability accounts.)

Selling a long-term asset will increase cash and will decrease a long-term asset account.
3. Which of the following will result in a decrease in working capital?

For the total amount of working capital to change, there must be a transaction that involves a working capital account and an account that is outside of the working capital accounts. (The working capital accounts are the current asset accounts and the current liability accounts.)

Repaying a long-term loan will decrease cash and will decrease a long-term liability account.

(Prepaying 6 months of property insurance is not the correct answer because Cash and Prepaid Insurance are both current asset accounts, which are therefore working capital accounts.)
4. Which of the following will not increase the total amount of working capital, but will increase a company’s liquidity?

Collecting an account receivable means receiving cash from a customer. A higher cash balance means more liquidity. However, working capital does not increase since both accounts receivable and cash are current assets.

(Paying out cash to reduce accounts payable will reduce the company's liquidity.)

(Purchasing inventory items on credit will not increase the company's liquidity.)
5. A company has current assets of $100,000; noncurrent assets of $130,000; current liabilities of $80,000; noncurrent liabilities of $90,000; and stockholders’ equity of $60,000. What is the amount of its working capital?

Working capital = current assets minus current liabilities.
Working capital = $100,000 minus $80,000
Working capital = $20,000
6. A company has cash of $20,000; accounts receivable of $60,000; inventory of $115,000; prepaid expenses of $5,000; noncurrent assets of $140,000; current liabilities of $100,000; noncurrent liabilities of $80,000; and stockholders’ equity of $160,000. What is the company’s current ratio?

Current ratio = current assets divided by current liabilities

Current assets = $20,000 + $60,000 + $115,000 + $5,000
Current assets = $200,000

Current ratio = $200,000 divided by $100,000 of current liabilities
Current ratio = 2 to 1
7. A company has cash of $20,000; accounts receivable of $60,000; inventory of $115,000; prepaid expenses of $5,000; noncurrent assets of $140,000; current liabilities of $100,000; noncurrent liabilities of $80,000; and stockholders’ equity of $160,000. What is the company’s quick ratio?

The quick ratio (or acid test ratio) = quick assets divided by the amount of current liabilities. The quick assets include cash, temporary investments, and accounts receivable. (Inventory and prepaid expenses are current assets; however, they are not quick assets.)
Quick ratio = $80,000 divided by $100,000
Quick ratio = 0.8 to 1
8. In the past year a company had cash sales of $200,000 plus it had $400,000 of sales with credit terms of net 30 days. Its sales, accounts receivable and inventory had uniform increases each month of the year. The cost of goods sold was a constant 70% of sales. The balance in accounts receivable was $40,000 at the start of the year and $60,000 at the end of the year. The balance in inventory began at $95,000 and ended at $105,000. The accounts receivable turnover ratio for the year was ______ times.

Let's refer to the receivables turnover ratio as RTR.

RTR = net credit sales divided by average accounts receivable.
The average accounts receivable was $50,000 [($40,000 + $60,000) divided by 2]

RTR = $400,000 of net credit sales divided by $50,000 the average accounts receivable
RTR = 8
9. In the past year a company had cash sales of $200,000 plus it had $400,000 of sales with credit terms of net 30 days. Its sales, accounts receivable and inventory had constant increases each month of the year. The cost of goods sold was a constant 70% of sales. The balance in accounts receivable was $40,000 at the start of the year and $60,000 at the end of the year. The balance in inventory began at $95,000 and ended at $105,000. The average collection period during the year was closest to which of the following?

Average collection period = 360 days divided by receivable turnover ratio

Average collection period = 360 days divided by 8 (see question #8)
Average collection period = 45 days
10. In the past year a company had cash sales of $200,000 plus it had $400,000 of sales with credit terms of net 30 days. Its sales, accounts receivable and inventory had constant increases each month of the year. The cost of goods sold was a constant 70% of sales. The balance in accounts receivable was $40,000 at the start of the year and $60,000 at the end of the year. The balance in inventory began at $95,000 and ended at $105,000. The inventory turnover ratio for the year was closest to which of the following?

Let's refer to Inventory turnover ratio as ITR.
ITR = cost of goods sold divided by average inventory

Cost of goods sold (COGS) in this question = sales X 70%
COGS = $600,000 X 70% = $420,000

ITR = $420,000 divided by the average inventory of $100,000
Inventory turnover ratio = 4.2 times
11. In the past year a company had cash sales of $200,000 plus it had $400,000 of sales with credit terms of net 30 days. Its sales, accounts receivable and inventory had constant increases each month of the year. The cost of goods sold was a constant 70% of sales. The balance in accounts receivable was $40,000 at the start of the year and $60,000 at the end of the year. The balance in inventory began at $95,000 and ended at $105,000. The approximate days’ sales in inventory during the year was closest to which of the following?

Let's refer to the days' sales in inventory as DSI.
DSI = 360 days divided by the inventory turnover ratio
DSI = 360 divided by 4.2 (see question #10)
Days' sales in inventory = 85.7 days
12. When a company offers an early payment discount of 1/10, net 30, the cash discount is equivalent to an annual percentage rate of approximately _________.

Saving 1% of the invoice amount by paying a vendor's invoice 20 days early (paying in 10 days instead of paying in the required 30 days) can be converted to an annual amount by multiplying the amounts by 18:

1% X 18 = 18% and 20 days X 18 = 360 days.
Hence the annualized percentage is 18%.
13. A company has $360,000 of current assets and $240,000 of current liabilities before making a $40,000 payment to reduce its accounts payable. How will the payment change the total amount of its working capital and its current ratio?

The amount of working capital prior to the $40,000 payment was $120,000 ($360,000 minus $240,000).

After the payment, the amount of working capital will also be $120,000 ($320,000 minus $200,000).
Therefore, there is no change in the total amount of working capital.

The current ratio prior to the $40,000 payment was $360,000 divided by $240,000 = 1.5 or 1.5:1.

After the payment, the current ratio will be $320,000 divided by $200,000 = 1.6 or 1.6:1.
Therefore, the current ratio will change.
14. If obsolete inventory items that have no salvage value are included at their original cost in a company’s Inventory account, which of the following will still be accurate?

Since inventory is not a quick asset (and the quick ratio uses only the quick assets), the quick ratio is still accurate.

On the other hand, the total amount of current assets is overstated (the reported amount is larger than it should be) causing both the amount of working capital and the current ratio to not be accurate.

Since the average amount of inventory is also overstated by continuing to report the obsolete inventory items at their original cost, the days' sales in inventory will not be accurate.
15. Which one of the financial statements is likely to provide most of the amounts contained in the management discussion of liquidity in a U.S. corporation’s Form 10-K?

Since liquidity is based on a corporation's cash flowing so that it can pay its obligations when they come due, the statement of cash flows (also referred to as SCF and cash flow statement) will have the most amounts pertaining to liquidity.
16. The inventory turnover ratio, receivables turnover ratio, average collection period, and days’ sales in inventory will be based on amounts from which type of general ledger accounts?

The four ratios listed will involve both a balance sheet account (accounts receivable, inventory) and an income statement account (credit sales, cost of goods sold).

Because the balance sheet amounts represent only the final moment of the accounting year, we should find the average amount during the year for the balance sheet accounts. This is necessary because the income statement accounts accumulate the transaction amounts occurring throughout the entire year.
17. How will the speed in which current assets are converted to cash affect the company’s total amount of working capital and liquidity?

Converting inventory and/or accounts receivable to cash more quickly will not change the total amount of current assets. Therefore, there will be no change in the total amount of a company's working capital.

However, increasing the speed in which inventory and/or accounts receivable are converted to cash will mean that the company will have more liquidity. In other words, it will have the cash available sooner in order to pay its obligations when they come due.
18. Assume that a company follows the accrual method of accounting. If the company uses its business credit card to pay for an expense of $5,000 instead of writing a check, will the company’s total amount of working capital end up being the same?

Under the accrual method of accounting, the company will have to record the $5,000 expense when it occurs. If the business credit card is used, the company will have to increase its current liabilities (such as Accrued Liabilities/Expenses) thereby reducing its working capital by $5,000. If instead, the company writes a check for $5,000 the current asset Cash is reduced...thereby reducing working capital by $5,000. Either way, working capital will be reduced by the same amount.
19. Which of the following working capital accounts will not be included in the cash flows from operating activities section of the statement of cash flows?

The changes in short-term notes payable as well as long-term notes payable are reported in the statement of cash flows under the heading of cash flows from financing activities. Therefore, the changes in short-term notes payable are not reported under the heading of cash flows from operating activities.
20. At the start of the previous year, a company had current liabilities of $150,000 which increased by a constant amount each month and ended the year at $250,000. The company’s total liabilities increased from $350,000 to $450,000. The company’s statement of cash flows showed net cash flows from operating activities of $180,000. The company’s operating cash flow ratio for the previous year was closest to which of the following?

Operating cash flow ratio = net cash provided by operating activities divided by the average amount of current liabilities.

Operating cash flow ratio = $180,000 divided by $200,000 (the average amount of current liabilities)
Operating cash flow ratio = 90%

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Working Capital and Liquidity(Quick Test #2 with Coaching)

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