3.1 Activity Ratios

Question 1

Formula for Accounts Receivable Turnover

Answer 1

Net credit sales / average accounts receivable

avg. accounts receivable = (beginning AR + Ending AR) / 2

Higher is better

Question 2

Formula for days’ sales outstanding in receivables

Answer 2

Days in year / Accounts receivable turnover

Lower is better

Question 3

A corporation has a decrease in its operating cycle and a decrease in its cash cycle. All else remaining unchanged, this would occur if the corporation’s

A. Payables period increased
B. Receivables period decreased
C. Receivables period increased
D. Inventory period increase

Answer 3

B. Receivables period decreased

Question 4

The company had net accounts receivable of $168,000 and $147,000 at the beginning and end of the year, respectively. The company’s net income for the year was $204,000 on $1,700,000 in total sales. Cash sales were 6% of total sales. The company’s average accounts receivable turnover ratio for the year is

A. 9.51
B. 10.15
C. 10.79
D. 10.87

Answer 4

B. 10.15

AR Turnover = Net credit sales / average AR

Net credit sales
= total sales $1,700,000 x 94% credit sales percentage
= $1,598.000

Average accounts receivable
= (168,000 + 147,000) / 2 = 157,500

AR turnover
= 1,598,000 / 157,500 = 10.146 times

Question 5

Formula for Inventory Turnover

Answer 5

Inventory turnover = COGS / Average inventory

Average inventory = (Beg inventory + Ending inventory) / 2

Higher is better

Question 6

Formula for days’ sales in inventory

Answer 6

Days’ sales in inventory = days in year / inventory turnover

Question 7

Formula for Accounts Payable turnover

Answer 7

AP turnover = purchases / average accounts payable

Avg. AP = (Beg. AP + Ending AP) / 2

Question 8

Formula for Days’ purchases in AP

Answer 8

Days’ purchases in AP = days in year / AP turnover

Question 9

Definition Cash Cycle

Answer 9

portion of the operating cycle when we do not have cash, when cash is tied up in the form of inventory or accounts receivable

portion of operating cycle not accounted for by days’ purchases in accounts payable

Question 10

Formula for cash cycle

Answer 10

cash cycle = operating cycle - days’ purchases in accounts payable

operating cycle = days’ sales outstanding in receivable + days’ sales in inventory

Question 11

Explain how the use of financial ratios can be advantageous to management.

Answer 11

Financial ratios relate financial statement line items to each other. By calculating standardized ratios, management can asses the firm’s liquidity, financial activity, solvency, and profitability. Management can also compare the firm’s performance to that of others in its industry.

Question 12

Based on the data presented below, what is the cost of sales for the year?

Current ratio 3.5
Acid test ratio 3.0
Year-end current liabilities $600,000
Beginning inventory $500,000
Inventory turnover 8.0

A. $1,600,000
B. $2,400,000
C. $3,200,000
D. $6,400,000

Answer 12

C. $3,200,000

The current ratio is the ratio of current assets to current liabilities. Since the current ratio and current liabilities are known, current assets can be determined as follows:
Current assets ÷ Current liabilities = Current ratio
Current assets ÷ $600,000 = 3.5
Current assets = $600,000 × 3.5 = $2,100,000

Quick assets can be determined similarly:
Quick assets ÷ Current liabilities = Acid test ratio
Quick assets ÷ $600,000 = 3.0
Quick assets = $600,000 × 3.0 = $1,800,000
Assuming the company had no prepaid expenses, the difference between current assets and quick assets is inventory.
Ending inventory = Current assets – Quick assets
= $2,100,000 – $1,800,000
= $300,000

Once ending inventory is known, average inventory can be determined [($500,000 + $300,000) ÷ 2 = $400,000], and, finally, cost of sales can be calculated:
Cost of sales ÷ Average inventory = Inventory turnover
Cost of sales ÷ $400,000 = 8.0
Cost of sales = $400,000 × 8.0 = $3,200,000

Question 13

The difference between average and ending inventory is immaterial.

Current ratio 2.0
Quick ratio 1.5
Current liabilities $120,000
Inventory turnover (based on cost of goods sold) 8 times
Gross profit margin 40%

Net sales for the year were

A. $800,000
B. $480,000
C. $1,200,000
D. $240,000

Answer 13

A. $800,000

Net sales can be calculated indirectly from the inventory turnover ratio and the other ratios given.

If the current ratio is 2.0, and current liabilities are $120,000, current assets must be $240,000. Similarly, if the quick ratio is 1.5, the total quick assets must be $180,000. The only major difference between quick assets and current assets is that inventory is not included in the definition of quick assets. Consequently, ending inventory must be $60,000 ($240,000 - $180,000). The inventory turnover ratio (COGS / Avg. inventory) is 8. Thus, COGS must be 8 times average inventory, or $480,000, given no material difference between average and ending inventory. If the gross profit margin is 40%, the COGS percentage is 60%. COGS equals 60% of sales, and net sales must be $800,000 ($480,000 / 60%).

Question 14

A change in credit policy has caused an increase in sales, an increase in discounts taken, a decrease in the amount of bad debts, and a decrease in the investment in accounts receivable. Based upon this information, the company’s

A. Average collection period has decreased.
B. Percentage discount offered has decreased.
C. Accounts receivable turnover has decreased.
D. Working capital has increased.

Answer 14

A. Average collection period has decreased.

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.

Question 15

The year-end financial statements for Queen Bikes reflect the data presented as follows. Ten percent of Queen’s net sales are in cash.

Net sales
Year 1: 1,500 units at $100
Year 2: 1,200 units at $100
Year 3: 1,200 units at $125

Ending inventory
Year 1: 100 units at $50
Year 2: 100 units at $50
Year 3: 100 units at $50

Average receivables
Year 1: $12,500
Year 2: $12,000
Year 3: $14,400

Net income
Year 1: $18,750
Year 2: $ 9,400
Year 3: $26,350

Queen’s inventory turnover ratios for Year 2 and Year 3 are

A. 24 and 24, respectively.
B. 12 and 18, respectively.
C. 12 and 12, respectively.
D. 18 and 18, respectively.

Answer 15

C. 12 and 12, respectively.

The cost of the 1,200 units sold in Year 2 at $50 each would have been $60,000. Dividing the $60,000 cost of sales by the $5,000 average inventory results in a turnover of 12. The 1,200 units sold in Year 3 also would have cost $60,000 and the turnover would again be 12.

Question 16

The year-end financial statements for Queen Bikes reflect the data presented as follows. Ten percent of Queen’s net sales are in cash.

Net sales
Year 1: 1,500 units at $100
Year 2: 1,200 units at $100
Year 3: 1,200 units at $125

Ending inventory
Year 1: 100 units at $50
Year 2: 100 units at $50
Year 3: 100 units at $50

Average receivables
Year 1: $12,500
Year 2: $12,000
Year 3: $14,400

Net income
Year 1: $18,750
Year 2: $ 9,400
Year 3: $26,350

Queen’s receivables turnover ratios for Year 2 and Year 3 are

A. 10.8 and 9.0, respectively.
B. 9.0 and 9.375, respectively.
C. 10.00 and 10.42, respectively.
D. 1.00 and 1.04, respectively.

Answer 16

B. 9.0 and 9.375, respectively.

The receivables turnover ratio equals net credit sales divided by average accounts receivables. For Year 2 the calculation is [($120,000 × .9) ÷ $12,000] = 9.0, and for Year 3 it is [($150,000 × .9) ÷ $14,400] = 9.375.

Question 17

A firm has a current ratio of 2.5 and a quick ratio of 2.0. If the firm experienced $2 million in cost of sales and sustains an inventory turnover of 8.0, what are the firm’s current assets?

A. $1,000,000
B. $500,000
C. $1,500,000
D. $1,250,000

Answer 17

D. $1,250,000

The only major difference between the current ratio and the quick ratio is the inclusion of inventory in the numerator. If cost of sales is $2 million and inventory turns over 8 times per year, then average inventory is $250,000 ($2,000,000 ÷ 8). Since the only difference between the two ratios is inventory, inventory must equal .5 (2.5 – 2.0) times current liabilities; therefore, current liabilities are $500,000. Thus, current assets divided by $500,000 equals 2.5. Therefore, current assets must equal $1,250,000 (2.5 × $500,000).

Question 18

Formula for Asset Turnover

Answer 18

Asset Turnover = Net sales / average total assets

Question 19

The selected data pertain to a company at December 31:

Quick assets $208,000
Acid test ratio 2.6 to 1
Current ratio 3.5 to 1
Net sales for the year $1,800,000
Cost of sales for the year $990,000
Average total assets for the year $1,200,000

The company’s asset turnover ratio for the year is
A. .675
B. .825
C. 1.21
D. 1.50

Answer 19

D. 1.50

The asset turnover ratio equals $1,800,000 of net sales divided by $1,200,000 of average total assets. The asset turnover ratio is therefore equal to 1.50.

Question 20

The ratio that measures a firm’s ability to generate sales from its assets is

A. Days’ sales in inventory.
B. Sales to working capital.
C. Days’ sales in receivables.
D. Asset turnover.

Answer 20

D. Asset turnover.

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.

Question 21

A company has $3 million per year in credit sales. The company’s average days’ sales outstanding is 40 days. Assuming a 360-day year, what is the company’s average amount of accounts receivable outstanding?

A. $500,000
B. $333,333
C. $250,000
D. $75,000

Answer 21

B. $333,333

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.

Question 22

A company computed the following items from its financial records for the current year:
Current ratio 2 to 1
Inventory turnover 54 days
Accounts receivable turnover 24 days
Current liabilities turnover 36 days

The number of days in the operating cycle for the current year was
A. 60
B. 90
C. 78
D. 42

Answer 22

C. 78

The operating cycle is the time needed to turn cash into inventory, inventory into receivables, and receivables back into cash. It is equal to the sum of the number of days’ sales in inventory and the number of days’ sales in receivables. The number of days’ sales in inventory is given as 54 days. The number of days’ sales in receivables is given as 24. Therefore, the number of days in the operating cycle is 78 (54 + 24).

Question 23

Accounts receivable turnover ratio will normally decrease as a result of

A. The write-off of an uncollectible account (assume the use of the allowance for credit losses method).
B. A significant sales volume decrease near the end of the accounting period.
C. An increase in cash sales in proportion to credit sales.
D. A change in credit policy to lengthen the period for cash discounts.

Answer 23

D. A change in credit policy to lengthen the period for cash discounts.

The accounts receivable turnover ratio equals net credit sales divided by average receivables. Hence, it will decrease if a company lengthens the credit period or the discount period because the denominator will increase as receivables are held for longer times.

Question 24

A company sells 10,000 skateboards a year at $66 each. All sales are on credit, with terms of 3/10, net 30, that is, a 3% discount if payment is made within 10 days; otherwise full payment is due at the end of 30 days. One half of the customers are expected to take advantage of the discount and pay on day 10. The other half are expected to pay on day 30. Sales are expected to be uniform throughout the year for both types of customers.

What is the expected average collection period for the company?
A. 5 days.
B. 10 days.
C. 15 days.
D. 20 days.

Answer 24

D. 20 days.

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 [0.5(10 days) + 0.5(30 days)].

Question 25

To determine the operating cycle for a retail department store, which one of the following pairs of items is needed?

A. Days’ sales in accounts receivable and average merchandise inventory.
B. Cash turnover and net sales.
C. Accounts receivable turnover and inventory turnover.
D. Asset turnover and return on sales.

Answer 25

C. Accounts receivable turnover and inventory turnover.

The operating cycle is the time needed to turn cash into inventory, inventory into receivables, and receivables back into cash. For a retailer, it is the time from purchase of inventory to collection of cash. Thus, the operating cycle of a retailer is equal to the sum of the number of days’ sales in inventory and the number of days’ sales in receivables. Inventory turnover equals cost of goods sold divided by average inventory. The days’ sales in inventory equals 365 (or another period chosen by the analyst) divided by the inventory turnover. Accounts receivable turnover equals net credit sales divided by average receivables. The days’ sales in receivables equals 365 (or other number) divided by the accounts receivable turnover.

Question 26

A corporation experiences a decrease in sales and cost of goods sold, an increase in accounts receivable, and no change in inventory. If all else is held constant, what is the total effect of these changes on the receivables turnover and inventory ratios?

Inventory Turnover: Increased/Decreased
Receivables Turnover: Increased/Decreased

Answer 26

Inventory Turnover: Decreased
Receivables Turnover: Decreased

Cost of goods sold is the numerator of the inventory turnover ratio and average inventory is the denominator. A decrease in the numerator accompanied by an unchanged denominator results in a decrease in the overall ratio. Net credit sales is the numerator of the receivables turnover ratio and average net receivables is the denominator. A decrease in the numerator and an increase in the denominator result in a decrease in the overall ratio.