The balance sheet for Peterson Manufacturing Company is presented below
Peterson Mfg. Co.
Balance Sheet
December 31, 1995
Cash $32,000 Current liabilities $72,000
Accounts receivable 40,000 Long-term liabilities 48,000
Inventories 48,000 Common equity 120,000
Total current assets $120,000
Net fixed assets 120,000
Total $240,000 Total $240,000
During 2009, the firm earned $28,000 after taxes based on net sales of $480,000.
a. Calculate Peterson's current ratio and net working capital.
b. Assume that Peterson's uses $20,000 of its cash to reduce current liabilities. Recompute the current ratio and net working capital.
c. What effect, if any, does the change proposed in question b have on Peterson's liquidity.
Answer:
a. Current ratio = ($120,000)/($72,000) = 1.67
Net working capital = $120,000 - $72,000 = $48,000
b. Current ratio = ($100,000)/($52,000) = 1.92
Net working capital = $100,000 - $52,000 = $48,000
c. Yes, the firm's liquidity position as measured by the current ratio improves slightly but the amount of net working capital is less. The composition of Peterson's current assets is less liquid than before because cash is the most liquid asset.
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