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The Effect of Accounting Transactions on Liquidity Ratios

The Lux Company experiences the following unrelated events and transactions during Year 1. The company's existing current ratio is 2:1 and its quick ratio is 1.2:1.

1. Lux wrote off $5,000 of accounts receivable as uncollectible.
2. A bank notifies Lux that a customer's check for $411 is returned marked insufficient funds. The customer is bankrupt.
3. The owners of Lux Company make additional cash investment of $7,500.
4. Inventory costing $600 is judged obsolete when a physical inventory is taken.
5. Lux declares a $5,000 cash dividend to be paid during the first week of the next reporting period.
6. Lux purchases long-term investments for $10,000.
7. Accounts payable of $9,000 are paid.
8. Lux borrows $1,200 rom a bank and gives a 90-day 6% promissory note in exchange.
9. Lux sells a vacant lot for $20,000 that had been used in its operations.
10. A three-year insurance policy is purchased or $1,500.

Separately evaluate the immediate effect of each transaction on the company's

a. Current ratio.

b. Quick (acid-test) ratio.

c. Working capital.

Solution Preview

Before answering the questions, let us define the terms. Current assets include cash, accounts receivable, inventory, and prepaid expenses expected to be used within a year. Current liabilities include accounts payable, dividends payable, and short-term notes payable. The current ratio is the ratio of all current assets to all current liabilities. The quick, or acid-test, ratio is the ratio of all current assets except inventory to all current liabilities. Working capital is the excess of all current assets over all current liabilities.

The easiest way to solve a ratio problem is to assign numbers to each side of the ratio. For argument sake, I will assign $100,000 to all current assets, $40,000 to inventory only, and $50,000 to all current liabilities. We are doing this just to find out the direction of each measure; do not use these amounts in your answer!

1. Under the allowance method, the estimated amount of uncollectible receivables reduces accounts receivable (by increasing the allowance for doubtful accounts) and increases bad debts expense. In this case, total current assets will fall by $5,000. Thus, the current ratio will fall from 2:1 ($100,000:$50,000) to 1.9:1 ($95,000:$50,000), the quick ratio will fall from 1.2:1 ($60,000:$50,000) to 1.1:1 ($55,000:$50,000) and net working capital will fall from $50,000 ($100,000-$50,000) to $45,000 ($95,000-$50,000).

2. Under the ...