Question

Astro Languet established Languet Products Co. as a sole proprietorship on January 5, 2020. At the company’s year end of December 31, 2020, the accounts had the following balances (in thousands):

Current assets, excluding inventory		$10
Other assets		107
Current liabilities		30
Long-term bank loan		50
Owner’s investment (excluding income)		40
Purchases during year
Jan. 2: 5,000 @ $11		55
June 30: 8,000 @ $12		96
Dec. 10: 6,000 @ $16		96
		247
Sales		284
Other expenses		40

A count of ending inventory on December 31, 2020, showed there were 4,000 units on hand.
Astro is now preparing financial statements for the year. He is aware that inventory may be costed using the FIFO or weighted average cost formula. He is unsure of which one to use and asks for your assistance. In discussions with Astro, you learn the following.

1.		Suppliers to Languet Products provide goods at regular prices as long as Languet Products’ current ratio is at least 2 to 1. If this ratio is lower, the suppliers increase their price by 10% in order to compensate for what they consider to be a substantial credit risk.
2.		The terms of the long-term bank loan include the bank’s ability to demand immediate repayment of the loan if the debt to total assets ratio is greater than 45%.
3.		Astro thinks that, for the company to be a success, the rate of return on total assets should be at least 30%.
4.		Astro has an agreement with the company’s only employee that, for each full percentage point above a 25% rate of return on total assets, she will be given an additional one day off with pay in the following year.

a) Discuss the impact of using the FIFO cost formula versus the weighted average cost formula on the key ratios.

Current ratio:
FIFO:		2.47
W.A.:		2.07
Debt to total assets ratio:
FIFO:		44.2%
W.A:		47.3%
Rate of return on total assets:
FIFO:		33.7%
W.A.:		29.0%

b) Which method do you recommend? Explain briefly.

c) Considering the choice of inventory cost formulas that are available, do the ratios noted above adequately measure the financial performance of Languet Products from the perspective of the users?

Answer 1

a) Discuss the impact of using the FIFO cost formula versus the weighted average cost formula on the key ratios.

b) Which method do you recommend? Explain briefly.

c) Considering the choice of inventory cost formulas that are available, do the ratios noted above adequately measure the financial performance of Languet Products from the perspective of the users?

Refer to the below images for the above mentioned questions in a detailed way of solution with explanation.