Question 1

Minnie knows that Double Entry has a lot of short-term debt coming due in the next year, and wants to make sure that the company will have the ability to make the required payments. Given a troubling downturn in construction activity over the past couple of months, she is not confident that Double Entry can count on selling its current inventory of doors before the debt comes due. Which of the following ratios would be most relevant to Minnie?
A) current ratio
B) debt to equity ratio
C) return on sales
D) acid-test ratio

Accepted Answer

Liquidity ratios, such as the current ratio and the acid-test ratio, are calculated to provide insight into the ability of firms to meet their short-term debt obligations. They do this by comparing current assets (which are expected to convert into cash in the next year) to current liabilities (which must be paid within the year). In a situation where a firm may have difficulty selling its inventory, the acid-test ratio is a better measure of liquidity because the acid-test ratio excludes inventory from the calculation.

Question 2

Double Entry Door's suppliers maintained very stable prices for many years, but Minnie has noticed that the cost of doors has been rising steadily for the past few years. She is concerned that, given the company's current accounting methods of basing its cost on the most recent doors purchased, this will result in a much lower net income than in the past. The most likely reason for her concern is that Double Entry has apparently been using
A) the FIFO inventory valuation method to determine its cost of goods sold.
B) a great deal of equity financing to purchase the doors.
C) the LIFO inventory valuation method to determine its cost of goods sold.
D) a depreciation method based on the average value of inventory.

Accepted Answer

The LIFO inventory valuation method uses the cost of the last items bought to determine the cost of goods sold. With FIFO, the cost of goods sold is based on the oldest (first) items in inventory. In a period of rising inventory prices, LIFO would result in a higher cost of goods sold than FIFO. Since cost of goods sold is subtracted from revenue in the determination of net income, LIFO would result in a smaller net income.

Quiz 17: Understanding Accounting and Financial Information