Question

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.

1. 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.

2. In terms of the ratios provided, what conclusion(s) can be drawn regarding the company’s use of financial leverage during the 2015–2017 period?

3. Using the ratios provided, what conclusion(s) can be drawn regarding the company’s net investment in plant and equipment?

1. ?

2 ?

3 ?

Answer 1

(1)

current ratio is current assets/current liabilities

quick ratio is quick assets/current liabilities

quick assets doesnot include inventories.

if the current ratio is increasing this means that the company is having more current assets per current liability from the the previous year.

but if the current ratio is increasing but the quick ratio is decreasing this means the company is investing more in inventories than other current assets. current assets also include cash, accounts receivable and other short term investments.

this means the current ratio is increasing primarily because of more investment in inventory.

(2)

long-term debt to assets ratio and the debt to assets ratio can be used to assess the company's use of debt.

long term debt to asset ratio = long term debt/ total assets

debt to asset ratio = total debt/total asset

long term debt includes only non current debts whereas total debts includes both long term and short term debts or current or non current debts both.

Long Term Debt to Asset ratio is the ratio that represents the financial position of the company and the company’s ability to meet all its financial requirements. It shows the percentage of a company’s assets that are financed with loans and other financial obligations that are non current or long term in nature.

If these ratio decreases overtime this means the company is not prefering debts and using other sources of finance which include retained earnings and equity. If the company uses equity and retained earning as primary source of finance then the leverage decreases.

As we see that both long term debt to asset ratio and debt to asset ratio are decreasing hence the leverage is declining. The company is avoiding the use of debt to finance its short term and long term needs.

in addition this theory can be again reinforced by the decrease in return on common stock equity ratio.  

(3)

Sales to fixed asset is an efficiency ratio that indicates how well or efficiently a business uses fixed assets to generate sales.

return on asset is a profitability ratio that defines how profitable a company is related to its total assets.

we are asked to assess the company's net investment in fixed asset. Hence are primary concern shall be sales to fixed asset.

sales to fixed asset = revenue/fixed assets

if the ratio increases this means that the fixed asset are generating better revenue when compared to total fixed assets in use.

As the ratio is increasing hence the investment in fixed assets is having better returns when compared to 2020 fro 2017.