## Chapter 2

KNOWLEDGE CHECK 2.1

Use Exhibit 2.1 to calculate Leon’s working capital and current ratio on January 1, 2010.

Working capital / = / Current assets – Current liabilities / = / \$286,184,000 – \$122,558,000
= / \$162,626,000
Current ratio / = / Current assets / = / \$286,184,000
Current liabilities / \$122,558,000
= / 2.34

KNOWLEDGE CHECK 2.2

Define the current ratio and explain what a decision maker would use it for.

The current ratio is defined as current assets ÷ current liabilities and indicates how many dollars of current assets there are for each dollar of current liabilities. A decision maker would use the current ratio to assess an entity’s liquidity—its ability to pay its current liabilities. The higher the current ratio the more current assets that are on hand to meet its current liabilities.

Define the debt-to-equity ratio and explain what a decision maker would use it for.

The debt-to-equity ratio is a measure of how an entity is financed and is defined as:

Debt-to-equity ratio / = / Liabilities
Shareholders’ equity

A decision maker would use the ratio to assess the risk of an entity. The higher the ratio the more risky the entity because debt and interest have to be paid regardless of whether the entity is doing well or poorly.

Use the following information about Didzbury Inc. to calculate its current ratio and debt-to-equity ratio on December 31, 2017:
Current assets, \$380,000
Current liabilities, \$250,000
Total liabilities, \$360,000
Total shareholders’ equity, \$180,000

Current ratio / = / Current assets / = / \$380,000
Current liabilities / \$250,000
= / 1.52
Debt-to-equity ratio / = / Liabilities / = / \$360,000
Shareholders’ equity / \$18,000
= / 2.00

KNOWLEDGE CHECK 2.3

During the summer, Hank operated a cart that sold hot dogs and cold drinks. At the end of the summer, Hank had collected \$6,500 from customers and paid \$3,300 to suppliers. At the end of the summer, Hank owed suppliers \$500 and he was owed \$200 by customers. The depreciation on his cart for the summer was \$800.

• What was Hank’s net income on a cash basis for the summer?

Cash net income = Cash collections – Cash payments

= \$6,500 – \$3,300

= \$3,200

• What was his net income on an accrual basis?

Accrual net income = Revenue – Expenses

= \$6,700 – \$3,800 – \$800

= \$2,100

• Why is his depreciation an expense under accrual accounting?

Under accrual accounting net income is the economic benefits an entity earned during a period less the economic costs of earning those benefits. Depreciation is an expense under accrual accounting because it represents the economic cost of using capital assets during a period.