Using Accounting Formulas
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We can now quickly calculate the Working Capital, the Current Ratio, and the Quick Ratio with this accounting information as follows:| 68,208 - 10,225 = 57,983 |
The Working Capital number is more than enough to pay down current liabilities coming due. Cash alone can easily cover the current liabilities. Of course, this may be an indication that Sunny Sunglasses has too many resources that can contribute to growth sitting in cash. This is also pushing the Current Ratio and Quick Ratio substantially above the industry averages.
Current Ratio:
| 68,208/10,225 = 6.7 |
Sunny Sunglasses Shop has more than six times the assets to pay down current liabilities. Even the Quick Ratio is above six.
Quick Ratio:
| (68,208 - 5,625)/10,225 = 6.1 |
Notice that the Quick Ratio removed Inventory from the calculation, as Inventory is not considered a "Quick Asset" quickly convertible to cash. Prepaid expenses would also be removed, but the balance was zero by the end of the year.
The second Accounting Formula, the Current Ratio, is high due to high receivables and cash amounts.
The Quick Ratio did not make a significant difference because inventory has a lower balance compared to the other current assets. Is inventory too low? As a new business owner, Sunny closely monitors his inventory to determine which models sell the fastest, and has not maintained high inventory levels as new models are arriving for the summer season. Maintaining inventory levels that are too low, however, can have a negative impact on sales.
To determine whether or not the inventory levels are adequate for Sunny Sunglasses Shop, click
Inventory Turnover Ratio.
The Cash and Receivable Balances are the main contributors of the high Current and Quick Ratios compared to industry averages.
The higher than normal cash balance is due to the the owner preparing to finance a new building on the land purchased for $20,000 for future use.
If, for example, the company financed a new building for $300,000, with a $30,000 down payment, the Balance Sheet and Accounting Ratios would be affected as follows:
Note that the cash balance of $30,000 has transferred from Current Assets to NonCurrent Assets: Land and Building, contributing $30,000 to the balance. The remaining $270,000 came from a new mortgage for the building. Assuming no current amount is due on the new mortgage, Noncurrent Assets increased by $300,000, Long-Liabilities increased by $270,000, and Current Assets decreased by $30,000 due to the cash down payment.As a reminder, this affects the Accounting Equation as follows:
| Assets = Liabilities + Owner's Equity |
| Assets (Cash) -$30,000 + Land and Building $300,000= Liabilities $270,000 + Change in Owner's Equity $0 |
The Working Capital Accounting Formula changed accordingly:
New Working Capital
| 38,208 - 10,225 = 27,983 |
Sunny Sunglasses Shop still has plenty of Current Assets to cover Current Liabilities coming due.
The Current Ratio and Quick Ratio are changed to:
New Current Ratio:
| 38,208/10,225 = 3.7 |
New Quick Ratio:
| (38,208 - 5,625)/10,225 = 3.2 |
This use of cash for financing a building for future growth has lowered the Current Ratio and Quick Ratio substantially, but remains higher than the industry average. Though this is not as significant of an issue as lower than normal Current and Quick Ratios, Sunny should next look into whether or not
Accounts Receivable Turnover
is too low.
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