Question

A company has a December year end and creates checks to pay their vendors towards the end of the month. The company creates all the proper journal entries at the time of creating the checks, but they do not mail the checks until January. Explain which, if any financial ratios are affected by this decision. Explain why this decision would be made.

Answer 1

• The decision to issue check and record the journal entries, but mailing the checks in the next month will have the following transactional effect:

--The Cash (Current Assets) will decrease by the amount of checks created, and
--The Accounts Payable (Current Liabilities) will be decreased by the same amount.

• The ratios that will be affected mostly because of this, and affect on them is demonstrated below through an example:
  Example: All figures below remain same except that Checks worth $ 5,000 are created and recorded which will be delivered next month.

		Before "Checks" were made	After "Checks" of $ 5,000 were made
A	Current Assets	$15,000	$10,000
B	Current Liabilities	$10,000	$5,000
C = A/B	Current Ratio	1.50	2.00
A	Quick Assets	$12,000	$7,000
B	Current Liabilities	$10,000	$5,000
C = A/B	Quick ratio	1.20	1.40
A	Total Liabilities	$20,000	$15,000
B	Total Equity	$20,000	$20,000
C = A/B	Debt to Equity Ratio	1.00	0.75
A	Total Liabilities	$20,000	$15,000
B	Total Assets	$40,000	$35,000
C = A/B	Total Debt Ratio	0.50	0.43

• The reason for such a decision is mainly to give “good image” to financial statement figures. Recording such checks, decreasing Accounts Payable amounts to “Window dressing” of financial data.

As you can see in above example, only ‘creation of check’ of $ 5,000 is having massive impact on those ratios.
All the ratios have changed ‘favourably’ because of that.
For example a Current Ratio of 2:1 (as in example) is considered more favourable that a 1.50:1 ratio (as it was before such checks creation.

This also changes investors’ decision in favour of the company.