Ratio Analysis Paper 5

Answer (A) is correct. In ratios that relate the income statement to the balance sheet (e.g., inventory turnover, asset turnover, receivables turnover, and return on assets), the balance sheet figure should be an average. The reason is that the income statement amounts represent activity over a period of time. Thus, the balance sheet figure should be adjusted to reflect assets available for use throughout the period.

Answer (D) is correct. Turnover ratios are activity ratios that measure management’s efficiency in using assets However the number of days’ sales in receivables (days in the year divided by the receivables turnover ratio), also known as the average collection period, and other turnover ratios are a measure of liquidity because these statistics show how long it will take to turn inventory into cash.

Answer (B) is correct. An increase in discounts taken accompanied by declines in receivables balances and doubtful accounts all indicate that collections on the increased sales have been accelerated. Accordingly, the average collection period must have declined. The average collection period is a ratio calculated by dividing the number of days in a year (365) by the receivable turnover. Thus, the higher the turnover, the shorter the average collection period. The turnover increases when either sales (the numerator) increase, or receivables (the denominator) decrease. Accomplishing both higher sales and a lower receivables increases the turnover and results in a shorter collection period.

Answer (A) is correct. An increase in discounts taken accompanied by declines in receivables balances and doubtful accounts all indicate that collections on the increased sales have been accelerated. Accordingly, the average collection period must have declined. The average collection period is a ratio calculated by dividing the number of days in a year (365) by the receivable turnover. Thus, the higher the turnover, the shorter the average collection period. The turnover increases when either sales (the numerator) increase, or receivables (the denominator) decrease. Accomplishing both higher sales and a lower receivables increases the turnover and results in a shorter collection period.

Answer (C) is correct. Like most ratios involving working capital, the working capital turnover (sales ÷ average working capital) is a measure of liquidity, which is the ability to meet obligations as they mature. However, it is also an activity measure, and a high turnover is preferable.

Answer (C) is correct. A high sales-to-working-capital ratio is usually favorable because working capital, by itself, is an unprofitable use of resources. A firm does not earn money by holding cash, inventory, or receivables. Such assets should be minimized. However, a high ratio of sales to working capital may indicate either very high sales (a good situation) or a low supply of working capital (a potentially bad situation). Thus, a high ratio could indicate that a firm is undercapitalized and does not have the resources to invest in working capital.

Answer (D) is correct. The average collection period is the average time it takes to receive payment from customers. Because one-half of the customers will pay on day 10 and half will pay on day 30, the average collection period is 20 days [.5(10 days) + .5(30 days)].

Answer (D) is correct. The expected average accounts receivable balance equals the average collection period times the credit sales per day. Thus, the average accounts receivable balance is $45,205.48 {[(10,000 units sold on credit × $66 price) ÷ 365 days] × 25 days}. The foregoing calculation assumes that receivables are recorded at their gross amounts.

Answer (B) is correct. Dividing $3 million of sales by 360 days results in an average of $8,333.33 per day. Multiplying the average daily sales by the 40 days outstanding results in $333,333.

Answer (D) is correct. Asset turnover measures the level of capital investment relative to sales volume. It is a measure of how well a company uses its assets. A high turnover is preferable because it signifies that a given level of resources is being used to generate greater sales.