Question

I am unsure of what is unclear. The instructions are:

1. Set up a worksheet for the solvency ratios--current ratio and the quick ratio.

2. Compute these ratios for Doctors Smith and Brown. To do so, you will need one additional piece of information that is not present on the doctors’ statements: their maximum annual debt service is $22,200.

Practice Exercise 11–II: Solvency Ratios

Refer to Doctors Smith and Brown’s financial statements presented in the preceding Chapter 10.

Required

1. Set up a worksheet for the solvency ratios .  current ratio and the quick ratio.

2. Compute these ratios for Doctors Smith and Brown. To do so, you will need one additional piece of information that is not present on the doctors’ statements: their maximum annual debt service is $22,200.

The requested information is below:

Exhibit 10-1 Westside Clinic Balance Sheet

Assets	December 31, 20x2		December 31, 20x1
Current Assets
Cash and cash equivalents		$190,000		$145,000
Accounts receivable (net)		250,000		300,000
Inventories		25,000		20,000
Prepaid Insurance		5,000		3,000
Total Current Assets		$470,000		$468,000
Property, Plant, and Equipment
Land	$100,000		$100,000
Buildings (net)	0		0
Equipment (net)	260,000		300,000
Net Property, Plant, and Equipment		360,000		400,000
Other Assets
Investments	$133,000		$32,000
Total Other Assets		133,000		32,000
Total Assets		$963,000		$900,000
Liabilities and Fund Balance
Current Liabilities
Current maturities of long-term debt	$52,000		$48,000
Accounts payable and accrued expenses	293,000		302,000
Total Current Liabilities		$345,000		$350,000
Long-Term Debt	$252,000		$300,000
Less Current Maturities of Long-Term Debt	?52,000		?48,000
Net Long-Term Debt		200,000		252,000
Total Liabilities		$545,000		$602,000
Fund Balances
Unrestricted fund balance	$418,000		$298,000
Restricted fund balance	0		0
Total Fund Balances		418,000		298,000
Total Liabilities		$963,000		$900,000

Exhibit 10-2 sets out the result of operations for two years, with the most current period in the left column. If the balance sheet is a snapshot, then the statement of revenue and expenses is a diary because it is a record of transactions over the period of a year. Operating revenues and operating expenses are set out first, with the result being income from operations of $115,000 ($2,000,000 less $1,885,000). Then other transactions are reported; in this case, interest income of $5,000 under the heading “Nonoperating Gains (Losses).” The total of $120,000 ($115,000 plus $5,000) is reported as an increase in fund balance. This figure carries forward to the next major report, known as the statement of changes in fund balance.

STATEMENT OF CHANGES IN FUND BALANCE/NET WORTH

Remember that our formula for a basic statement of revenue and expense looked like this:

Operating Revenue — Operating Expenses = Operating Income

Exhibit 10-2 Westside Clinic Statement of Revenue and Expenses

	For the Year Ending
Revenue	December 31, 20x2		December 31, 20x1
Net patient service revenue		$2,000,000		$1,850,000
Total operating revenue		$2,000,000		$1,850,000
Operating Expenses
Medical/surgical services	$600,000		$575,000
Therapy services	860,000		806,000
Other professional services	80,000		75,000
Support services	220,000		220,000
General services	65,000		60,000
Depreciation	40,000		40,000
Interest	20,000		24,000
Total operating expenses		1,885,000		1,800,000
Income from Operations		$115,000		$50,000
Nonoperating Gains (Losses)
Interest Income	$5,000		$2,000
Net nonoperating gains		5,000		2,000
Revenue and Gains in Excess of
Expenses and Losses		$120,000		$52,000
Increase in Unrestricted Fund Balance		$120,000		$52,000

The excess of revenue over expenses flows back into equity or fund balance through the mechanism of the statement of fund balance/net worth. Exhibit 10-3 shows a balance at the first of the year; then it adds the excess of revenue over expenses (in the amount of $115,000) plus some interest income (in the amount of $5,000) to arrive at the balance at the end of the year.

If you refer back to the balance sheet, you will see the $418,000 balance at the end of the year appearing on it. So we can think of the balance sheet, the statement of revenue and expenses, and the statement of changes in fund balance/net worth as locked together, with the statement of changes in fund balance being the mechanism that links the other two statements.

But there is one more major report—the statement of cash flows—and we will examine it next.

STATEMENT OF CASH FLOWS

To perceive why a statement of cash flows is necessary, we must first revisit the concept of accrual basis accounting. If cash is not paid or received when revenues and expenses are entered on the books—the usual situation in accrual accounting—what happens? The other side of the entry for revenues is accounts receivable, and the other side of the entry for expenses is accounts payable. These accounts rest on the balance sheet and have not yet been turned into cash. Another characteristic of accrual accounting is the recognition of depreciation. A capital asset—a piece of equipment, for example—is purchased for $20,000. It has a usable life of five years. So depreciation expense is recognized in each of the five years until the $20,000 is used up, or depreciated. (Land is an exception to this rule: it is never depreciated.) Depreciation is recognized within each year as an expense, but it does not represent a cash expense. This is a concept that now enters into the statement of cash flows.

Exhibit 10-4 presents the current period cash flow. In effect, this statement takes the accrual basis statements and converts them to a cash flow for the period through a series of reconciling adjustments that account for the noncash amounts.

Understanding the cash/noncash concept makes sense of this statement. The starting point is the income from operations, the subtotal from the statement of revenue and expense. Depreciation and interest are added back, and changes in asset and liability ac-counts, both positive and negative, are recognized. These adjustments account for operating activities. Next, capital and related financing activities are addressed; then investing activities are adjusted. The result is a net increase in cash and cash equivalents of $45,000 in our example. This figure is added to the cash balance at the beginning of the year ($145,000) to arrive at the cash balance at the end of the year ($190,000). Now refer back to the balance sheet, and you will find the cash balance is indeed $190,000. So the fourth major report—the statement of cash flows—interlocks with the other three major reports.

Exhibit 10-3 Westside Clinic Statement of Changes in Fund Balance

	For the Year Ending
Statement of Changes in Fund Balance	December 31, 20x2	December 31, 20x1
Balance First of Year	$298,000	$246,000
Revenue in Excess of Expenses	115,000	50,000
Interest Income	5,000	2,000
Balance End of Year	$418,000	$298,000

Exhibit 10-4 Westside Clinic Statement of Cash Flows

Statement of Cash Flows	For the Year Ending
	December 31, 20x2		December 31, 20x1
Operating Activities
Income from operations		$115,000		$50,000
Adjustments to reconcile income from
operations to net cash flows from
operating activities
Depreciation and amortization		40,000		40,000
Interest expense		20,000		24,000
Changes in asset and liability accounts
Patient accounts receivable		50,000		–250,000
Inventories		–5,000		–5,000
Prepaid expenses and other assets		–2,000		–1,000
Accounts payable and accrued expenses		–9,000		185,000
Net cash flow from operating activities		$209,000		$43,000
Cash Flows from Noncapital Financing Activities		0		0
Cash Flows from Capital and Related Financing Activities Acquisition of equipment	$    0		$(300,000)
Proceeds from loan for equipment	0		300,000
Interest paid on long-term obligations	–20,000		0
Repayment of long-term obligations	–48,000		0
Net cash flows from capital and related financing activities		–68,000		0
Cash Flows from Investing Activities
Interest income received	$5,000		$2,000
Investments purchased (net)	– 101,000		0
Net cash flows from investing activities		–96,000		2,000
Net Increase (Decrease) in Cash and Cash Equivalents		$45,000		$45,000
Cash and Cash Equivalents, Beginning of Year		145,000		100,000
Cash and Cash Equivalents, End of Year		$190,000		$145,000

Answer 1

	SOLVENCY RATIOS:
	Current Ratio	Current asset/Current Liabilities
	Quick Ratio	Quick Asset(Current asset -Inventory)/Current Liabilities
	Deby to Equity Ratio	Total Liabilities/Total Equity
	Interest Coverage Ratio	Earning before interest and taxes/Debt Service payment
	A	Current assets	$470,000
	B	Quick Assets	$440,000	(470000-25000-50000)
	C	Current liabilities	$345,000
	D	Total Liabilities	$545,000
	E	Total Equity	$418,000
	F	Earning Before Interest and Taxes(EBIT)	$135,000	(115000+20000)
	G	Debt service payments	$22,200
	A/C	Current Ratio	1.362319
	B/C	Quick Ratio	1.275362
	D/E	Deby to Equity Ratio	1.303828
	F/G	Interest Coverage Ratio	6.081081