Diane Corporation is preparing its 2012 balance sheet. The company records show

Question

Diane Corporation is preparing its 2012 balance sheet. The company records show the following selected amounts at the end of the accounting period, December 31, 2012.
Total assets $530,000
Total noncurrent assets $362,000
Liabilities:
Notes payable (8%, due in 5 years) $15,000
Accounts payable $56,000
Income taxes payable $14,000
Liability for withholding taxes $3,000
Rent revenue collected in advance $7,000
Bonds payable (due in 15 years) $90,000
Wages payable $7,000
Property taxes payable $3,000
Note payable (10%, due in 6 months) $12,000
Interest payable $400
Common stock $100,000
Required:
1. Compute (a) working capital and (b) the quick ratio (quick assets are $70,000). Why is working capital important to management? How do financial analysts use the quick ratio?
2. Would your computations be different if the company reported $250,000 worth of contingent liabilities in the notes to the statements? Explain.

Explanation / Answer

1) The formula for calculating the working capital ratio is Net working capital = Total current assets - TOtal current liabilities Total current assets : Total current assets = Total assets - TOtal non current assets = $530,000 - $362,000 = $168,000 Total current liabilities = Accounts payable + Income taxes payable + Wages payable + Property taxes payable + Notes payable (Due in 6months) + Interest payable + Rent revenue collected in advance + Liability for withholding taxes = $56,000 + $14,000 + $7,000 + $3,000 + $12,000 + $400 + $7,000 + $3,000 = $102,400 Substituting the values in the above formula, we get Net working capital = $168,000 - $102,400 = $65,600 b) Quick ratio = TOtal quick assets / Total current liabilities = $70,000 / $102,400 = 0.68 times Working capital is imporatant to financial management of a business, as it indicates the ability to pay its debts ot short-term liabilities, when they fall due.Working capital represents the funds avaialble with the company for day-to-day operations. Companies cannot survive with negative working capital as it represent the company has no funds for day-to-day operations. The effective management of working capital is necessary for achieving long-term and short-term goals. The quick ratio is a form of liquidity ratio. It is a measure of liquidity. It is sometimes referred to as "Acid-test ratio". This ratio is important to financial analysts as it measures the firms ability in meeting its short-term obligations and responsibilities with its most liquid assets. It excludes inventory as inventory is most illiquid asset which is difficult to liquidate. Therefore, one can estimate whether or not the business will be sustainable in the short-term in case of short-fall in the sales revenue. 2) Contingent liabilities are those liabilities that may occur in the future events. If they are probable and can be estimated, then they should be reported as a real liability and if they are not probable and cannot be estimated, then they should not be reported in the balance sheet. The Contingent liabilities are disclosed in the form of notes to financial statements. Though the company reports contingent liabilities, there would be no effect on the balance sheet, as they are reported as notes to financial statements and the effect is found only when the contingent liabilities turns to a liability.

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